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I would like to recommend two pieces to you, one being Howard Marks's (Oaktree Capital) client letter, and the other being Jeff Gundlach's market outlook for 2013, which should be available sometime Thursday on the Doubleline website. The latter is a useful antidote to prevailing wisdom, while the former is a powerful reminder of the role psychology can play in trumping fundamentals. Merely recognizing illusion isn't enough to navigate it successfully.

One illusion I've been seeing a lot of lately is how the global economy is doing so much better. This came as quite a surprise to me, yet the JP Morgan-Markit Global PMI was indeed released last Friday with the bold headline that global economic growth was at a nine-month high. A picture is worth a thousand words, so I strongly suggest that you click through to the report and look at the graph on its bottom right, which points to an unmistakable picture of global GDP steadily declining.

The PMI measures are diffusion measures that aren't very good at measuring activity levels. For example, suppose business at a company has gone from ten dollars of sales in January to one in September. Each monthly decline will pull the survey result down. But if sales then remain at a dollar for the next few months, the response goes from the "lower" category to the "same" and that pulls the diffusion measure back up. For the owner of the company, business can't get any worse, yet the PMI is saying business conditions are picking up. If you have no customers one month and none the next, the PMI is 50. No more decline!

A concrete example of this is Italy. The Markit Eurozone PMI reported Friday that Italy's all-sector output was at an 11-month high. Things must be looking up, right?

Here is a chart of Italy's industrial production from Econoday:

(click to enlarge)Italian Industrial Production December 2012

Do either the month-on-month or year-on-year changes look impressive to you? Or like 11-month highs?

The same report noted that Germany also returned to growth. Here's the Econoday chart of that country's industrial production:

(click to enlarge)Industrial Production: Germany January 2013

You may well wonder what's going on. Yet such headlines are picked up and repeated on all the news services, Reuters, Bloomberg, and so on. The stories in turn are read by the black-box trading algorithms ("algos"), who subsequently issue buy orders. They do so not because they are trading on the stories as genuine indicators of the real economy, but because they are trying to trade on the direction of investor psychology, which is herd-driven (and move-making). Their buy orders are sniffed by the high-frequency-trading (HFT) crowd, who try to front-run everything and thereby drive the prices up even more.

Other algorithms and traders are on the lookout for technical levels, in particular ones that might trigger short-covering. More fuel is added to the rally as the shorts are covered, and then the next batch of "news" is awaited. Rinse and repeat.

This phenomenon was very much in evidence last year during the first quarter of 2012, when the warmest weather on record made a hash of seasonal adjustment factors and led to inflated statistics being reported for several months running. The result was a stunning 12% rise in the S&P 500 and a steady stream of media-fueled hype about the economy reaching "escape velocity." In practice, GDP fell from a run rate of 4.1% in the fourth quarter of 2011 to 2.0% in the first quarter of 2012 and 1.3% in the second. The only escape that occurred was the market's flight from the clutches of reality.

More recently, the media has been filled with end-of-year stories about the market's great performance last year, usually embellished with remarks about the heartening US recovery (though the rate of GDP is once again declining) and central bank stimulus. One gets the impression of a sturdy band of investors toiling away last year as fragments of the rainbow appeared.

That's another illusion. Reality was something else: From April 2nd (the first trading day after the end of the first quarter, and a traditional buying day) through the end of the year, the markets were completely flat. The S&P was up fifty basis points (before dividends) over the last nine months (minus a day), while the Dow and the Nasdaq were down a little less than one percent.

In fact, the first quarter's gain nearly vanished by early June. From that point on, prices were held up by a mere handful of days predicated entirely on central bank liquidity that, in the ECB's case, wasn't even provided but only implied. Economic fundamentals slowed, earnings growth slowed, and revenue growth for most S&P 500 companies turned flat or negative by the end of the third quarter. But the market managed to hang on in the following way:

Date......................... Event....................................Market Gain

June 6 2012................ECB meeting...................................1.23%

July 25-26..................Draghi's "whatever it takes"...............3.64%

September 6...............Draghi's "unlimited" bond threat..........2.11%

September 13-14.........FOMC meeting and QE-infinity............2.03%

December 31st............Senate passes cliff extension.............1.69%

The five events above - all lasting about one trading day - produced a combined return of 12.34% in the S&P 500. In other words, the market was down 12% the rest of the time after the end of the first quarter, but for the central bank meetings (+10.5% combined) and day one of the cliff relief rally. Some recovery.

It's a good time to cite Mr. Mark's point, though, that attitudes about risk drive the major movements in the markets. I would go further and add that the combination of algorithmic trading and high-frequency trading methods, in effect both ways to try to ride the herd, are exaggerating the fluctuations. Informally I would guess them to be about doubling the amplitude, in large part because the tepid economy and fading rates of sales and earnings growth mean that the market lacks a solid motive. The waves from central bank liquidity and algo-trading rock the boat more because there's so little fundamental current to move it along.

The question in my mind, and the one I think matters to investors wondering if they should commit more money, is how much, if any of the phenomenon gets to be repeated over the coming weeks and months, perhaps in a compressed time frame. Knowing what the real economy was doing twelve months ago wasn't an investing advantage - if you didn't go along with the herd's belief in the weather illusion, you fell behind. The Bloomberg Global Aggregate Hedge Fund Index was up 1.1% last year.

The reality of the fiscal cliff mini-mini-bargain was the Economist rightly calling it "a feeble fix" and "America's European moment." Yet there are voices out singing about what a great thing it was for the markets, and so long as prices rise, those voices will have traction in the media. In the interlude between the mini-mini and whatever day in the next four to six weeks that the market - and the news flow - starts to succumb to the growing volume of noise about the debt showdown (maxi-maxi?), there are three sources of fire for driving the herd. Earnings estimates, economic estimates, and though it pains me to say it, the weather.

Next week is packed with economic data and the first big slug of Dow earnings reports. Earnings will always beat estimates between 60% and 70% of the time; the question now is whether revenue estimates were trimmed enough this time (they were a drag last quarter) and how the outlook might develop. Sentiment about fourth quarter earnings appears to be fairly pessimistic, meaning they have a better chance at surprising to the upside than the downside.

The outlook is usually optimistic in January, especially with regard to the second half. Alcoa's (NYSE:AA) earnings report was given favorable publicity for unexpected strength on its earnings beat, minimizing the fact that revenue declined from the previous year. I give a tentative edge to earnings (or the illusion thereof) as sentiment-friendly. But keep in mind that if the markets do manage to rise on "beats" while revenue is flat or down, the gains have typically faded quickly as the season ends.

Much of the economic data will be seasonally adjusted. The weather is turning warmer in the Northeast, but not as warm as last year and the western half of the country is battling below-average temperatures. It may take another month before the seasonal factors start to suffer from unfavorable comparisons, at which time the effects of the payroll tax cut are going to start kicking in too. How low will the bar be set?

Seasonally, the second half of January is often weak, as the impact of newly available investment money fades along with the fuss over the changing of the calendar. February looks like it's shaping up as a near-perfect storm of debt battles, downwardly revised estimates and the payroll tax bite.

We're not there yet, though, and the illusion could keep going a bit longer. The market is a long way from underbought, but isn't seriously overbought either. A little racing luck could push the S&P 500 index past its 52-week high and generate a breakout/capitulation rush for 1500, at which point most of the trading world is waiting to sell (but won't when the time comes, just in case the rally keeps going).

My thesis, similar to last week, is not to buy into the illusion, but don't throw yourself in front of the train yet either. If the market edges higher, it won't hurt your portfolio to edge out and wait for more dire times. The payroll tax cut is going to bite, the debt battle is going to bite - beyond the battling headlines, whether the end result is higher taxes or lower spending or both, the initial effect is going to be more drag - and counting on a fluke of the weather to bail us out again is too much to ask for.

However, experience suggests that there may still be too much worry around for the market to roll over. Something else could come along to set it off, like a lemon earnings report from Wells Fargo (NYSE:WFC) on Friday (I make no prediction thereof), but it isn't otherwise ripe enough to fall of its own accord. Yes, the VIX hit a 5 1/2 year low intra-day on Wednesday, but as an imminent timing indicator it isn't very good.

You could also stand pat. The one solid I pass along to you is this: If the SPYder does manage to creep up to 150 in the next few days or weeks (I give it about a 50-50 chance), do not do the capitulation trade, even if you have to sit on your hands or spend the day cleaning the basement.

It may not be quite ripe yet, it could be a couple of days or a couple of weeks, but the market is headed for a tumble. It may be next week, or it may be after we hit 1499 (at which point you will sell call options liberally), but it's one of the most treacherous times for making big bets. You should stand aside and start making contingency plans for what you'll do after the storm.

Source: The Market's Grand Illusion