Market's Solid Year Could Soon Fall Off a 'Cliff'

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The stock market's double-digit 2012 gains are giving traders some solace as they peer into the unknown that is 2013.

The actions of the next several days, when Congress returns from Christmas break, could determine whether the U.S. economy's recent improvement continues or hits the "fiscal cliff," resulting in a recession in the first half of the year. That will also determine the course for markets next year.

The fiscal cliff is the more than $600 billion hit the economy would feel from the end of dozens of tax breaks and the onset of automatic spending cuts, and it is the slam to confidence as well as the economy that analysts are worried about.

The S&P 500 Monday ended the day down 3.49 at 1426.7, and the Dow was down 51.76 at 13,139. For the year-to-date, the S&P is up more than 13 percent, the Dow is up nearly 8 percent, and the Nasdaq is up more than 15 percent.

Citigroup chief U.S. equity strategist Tobias Levkovich is optimistic that 2013 will bring more gains for stocks, and his target is 1,615 for the S&P 500. His 2012 target was 1,425.

"Unless Washington really flubs it, and what we mean by flubs it is not being able to do what we call a bungee jump post Jan. 1," he said on "Squawk on the Street." "In other words: Go off the cliff, create the crisis to form the consensus and coalescence of various forces to then respond to it. If they can't do that, and we have a debt ceiling lift, then that's a huge risk to the markets next year."

Congress returns Thursday, and President Barack Obama's parting words ahead of the holiday weekend were that there is hope a slimmed down deal could get done before Jan. 1, preserving tax breaks for 98 percent of Americans.

The House last Thursday put off a vote on a "Plan B," for lack of support, that would have raised taxes only on families earning $1 million or more. The White House has used $400,000 as an income threshold.

"They could possibly come to a deal where the most likely scenario is you get some framework toward a deal, and then they get it sometime early in the new year," said Bill Stone, chief investment strategist at PNC Wealth Management. The market is still pricing the idea that a deal gets done, he said.

Stone said the market could, however, still see volatility in response to developments in Washington at the end of the week.

"I think what you're seeing is every deal they've come up with so far, even the ones where they're far part, has a 20 percent dividends and capital gains tax rate, even for the highest incomes. I would argue you don't want to be knee-jerk and go do something," he said.

One concern was that the capital gains tax rate and dividend tax rate, both at 15 percent, would revert to past levels.

That would mean a 20 percent capital gains rate, and a dividend rate at income tax levels, which could revert to the Clinton-era 39.6 percent for the highest earners. The Affordable Care Act in 2013 adds 3.8 percent to those rates for the wealthiest Americans.

Oppenheimer Asset Management market technician Carter Worth sees the market ending the year lower than its closing level last Friday.

"Our own guess is that we end the year a fraction lower than where we are now, and that 1Q 2013 is a difficult period for equities," he wrote in a note. "Our own guess aside, the year that was 2012 is headed into the history books as a tremendous year for equities (despite all the fireworks). With a total return of 16.27 percent (as of last Fridays's close) the S&P 500 has put on quite a performance indeed."

Art Cashin, director of floor operations at UBS, said the market could see a "sigh of relief" rally if there is some resolution of cliff issues.

"If all we're doing is going past Dec. 31 and have to do something in the first couple of weeks in January, I don't think it rips apart the possibilities for next year," said Levkovich. "There are some good things happening, too."

The positives are some of the improving areas of the economy, including housing. Fresh S&P/Case Shiller home price data is expected Wednesday at 9 a.m. ET.

"I would argue the market is probably already looking forward to 2013 and we're looking for mid-single digit earnings growth this year," said Stone.

Stone said the economy in the fourth quarter has been showing signs of roughly 2 percent growth, and some data points, like jobless claims, have been showing improvement.

"How much that drop in consumer confidence and business confidence translates into real economic damage in the first quarter, depending on how long it takes them to get a deal done, it's really tough to know," he said.

If Congress doesn't act on the "cliff," the Congressional Budget Office predicts the economy could go into recession in the first half and unemployment could rise above 9 percent.