Everybody should read this post by Warren Mosler: more on the cliff. I very much agree with all of the macro observations he is making regarding the cliff and what it means for the stock market going forward. I do not think this was 'the top', I think that after a correction we will have a very nice dip to buy.
So, why do I think we will correct more? Why don't I think we are bottoming now? A few reasons: Because of the *uncertainty* associated with the fiscal cliff. Many pundits are saying that there will be some sort of 'deal' / the 'Grand Bargain' struck either before the end of the year or perhaps at the beginning of the year. The latter is the more interesting and 'uncertain' option being waved out. Basically the Democrats want us to go over the cliff 'just a little' to scare Republicans into some sort of deal. This is completely idiotic on two accounts:
1) The political machine has broken down and is playing chicken with the economy to pass legislation. In this regard the markets are reacting commensurately to this action, no one has any idea what to expect for tax planning going into the end of year. What will tax rates be for 2013? How long does this game of chicken get played? What if there really is no deal struck and the full force of the cliff goes all the way through 2013? Combined with a very dismal earnings season that started bad and got progressively worse (and a massive deficit reduction / full force of the fiscal cliff in 2013 would be bad news for corporate profits) has investors nervous for any delay in some sort of deal
2) There is no 'crisis' to begin with regarding the deficit. The private sector is still retrenched and is still saving (spending less than their income) due to the excesses (spending more than their income) accumulated during the housing bubble. They are rightfully repairing balance sheets. Unemployment is still very high but has been slightly coming down, which means that the private domestic sector is starting to come out of it shell but just barely. It is still fragile. Couple this with the fact that we have a trade deficit. Now in the macroeconomy there are three sectors: Government, Private Domestic and Foreign. The Foreign Sector is running a surplus (which is our trade deficit) and the Private Domestic Sector is running a surplus (saving more than their income to pay down debts) then by definition the Government Sector is running a deficit. And since the US won't magically start running trade surpluses any time soon and combined with the fact that the private sector is nowhere near done with its deleveraging cycle, the government will need to continue to run deficits for the next several years. This goal of trying to cut the deficit in the name of 'fiscal responsibility' will deprive the private domestic sector of income while they still need it desperately. The US Government is not a 'super-household', it issues its own currency. It never faces a 'solvency' constraint. The concept of 'fiscal sustainability' is inapplicable to the US Government. And because we have high unemployment and spare capacity (see the summary at the beginning of this post) we can 'afford' to continue these deficits before we start hitting the real constraint, which is inflation. There is no nominal constraint. For a very good and succinct presentation regarding the budget deficit, see this video by Stephanie Kelton. It is well worth 19 minutes of your time. (Update 11/16: Also read this well-timed post by Warren regarding the deficit).
Back to the markets, I still think there will be some sort of deal put in place regarding the fiscal cliff. Even mainstream economists agree that the full force of the fiscal cliff will put GDP negative in 2013 and virtually guarantee a recession. And while the parties are willing to play chicken with this issue, no one will want to accept responsibility for causing a recession.
Therefore I agree with Warren that the deficits although potentially lower will still be high enough to support aggregate demand (and corporate profits) and with the private sector still slowly coming out of its shell will also support aggregate demand (or be less of a drag as was the case in 2008-2011). Combined with the 'certainty' of a deal we should see a resumption of the cyclical bull market sometime early next year.
My take at any rate.