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In 2012 we emphasized real-world economic developments in our investment decision-making process and our outlook for financial markets. This resulted in a very conservative investment allocation and a consistently foreboding tone to our monthly Market Outlooks. The US economy did not perform well in 2012, but financial markets had a far different interpretation of reality in the second half of the year. The divergent paths of deteriorating economic fundamentals and rising market valuations naturally forced us to question our resolve on more than one occasion. Yet we refused to take the blue pill and embrace the fabricated reality on Wall Street that has been orchestrated by the Federal Reserve.

It is understandable to conclude that the economy is strengthening when stock and bond prices rise, as they have the past six months. Rising asset values invigorate the growing consensus of optimistic pundits, regardless of the underlying fundamentals. It drowns out the minority that questions progress with facts that prove otherwise. The consensus is further emboldened by the complicity of our incurious main-stream media to parrot only those data points that support the bullish narrative. If the data is not bullish, it is either ignored or seasonally adjusted so as to not disrupt the appearance of progress, which is easily bought by an American public that always looks for palatable alternatives to bad news. This is exactly how the asset bubbles in tech stocks and housing were blown before they burst.

The fact that the economy is creating approximately 150k jobs per month is good news, but just about every other aspect of the employment situation is disheartening. We are told the unemployment rate declined modestly last year, but the greatest incremental driver of the decline is the supposed drop in the labor force participation rate to a multi-decade low of 63%. Was the government counting the 22,000 applicants vying for 300 flight attendant positions with Delta last month?

During this recovery, the vast majority of the jobs have been created for our oldest demographic (age 55-69), while our most productive demographic (ages 24-55) has realized no net new job gains. Nearly 60% of the new jobs are paying hourly wages between $7-14. This is one reason that another 1.9 million Americans joined the ranks of food stamp recipients last year, exceeding the total number of jobs created. Knowing this reality, it is baffling to see the market's gullible response to data reported by government agencies that is continually massaged to illicit positive sentiment. Optimism must be grounded in realism.

The number of Americans seeking unemployment benefits fell last week to the lowest level in five years according to the Department of Labor, which pundits cited as evidence that employers were cutting fewer jobs-or did it? Initial claims for unemployment insurance declined on a seasonally-adjusted basis to 330k. In reality, the actual number of people filing initial claims was more than 436k. This figure was 20k more than the number who filed claims in the comparable week one year ago, and the second week in a row that claims rose year-over-year, which has not occurred in over two years. For no apparent reason, the Department of Labor dramatically increased the divisor it used to seasonally adjust the number reported this year, which is what led to the perceived decline. Yet this news made for a bullish market-moving headline.

The lack of improvement in the quality and quantity of jobs is the reason that median household income continues to decline. On an inflation-adjusted basis, it has declined 8% since 2007. The November surge in after-tax personal income, likely to be replicated in December, was heralded as a sign of a strengthening economy that would cushion the blow from the increase in the payroll tax. In reality, this increase of approximately $100 billion in income was the result of bonus payments, dividends and capital gains that were realized before year end to avoid the higher tax rates in 2013. As a result, personal income is likely to decline significantly in the first quarter. It also does nothing to offset the headwind of a 2% increase in the payroll tax. The recipients of year-end bonuses are not the same people that will be struggling when an extra $20 is withheld from their paycheck every week.

There has been much fanfare about the progress in deleveraging the balance sheet of the American consumer during this recovery. This assertion has fueled optimism with respect to growth in consumer spending. We don't see it. The only deleveraging that has occurred is within the home mortgage segment, but the 10% decline (approximately $1 trillion) in outstanding mortgage balances from the peak has been the result of foreclosures, short sales and write downs. The commensurate percentage decline in real incomes during the same time frame has resulted in no improvement in debt-to-income ratios. At the same time, consumer debt has hit an all-time high of $2.7 trillion, driven primarily by auto and student loans. Student loans now top $1 trillion, and the percentage of loans more than 90 days delinquent surged from 9 % to 11% at the end of last year. This is not indicative of a strengthening labor market

Has the housing market stabilized? We don't know. You have to strip out the cash purchases made by individual investors, hedge funds and private equity firms that have bid up prices at the low end of the market, effectively shutting out would be first-time home buyers, and making a significant contribution to the 6% increase in median home prices nationwide in 2012. This increase is a positive, but it does little to help the 14 million homeowners that have negative equity. Additionally, there are an estimated 1-2 million homes owned by banks that are at varying stages of foreclosure. Bank of America has nearly 1 million loans that are at least 60 days delinquent. If we account for these variables in the supply and demand equation, the rise in home prices looks fragile at best.

We were evidently concerned for no reason about the spending cuts and tax increases scheduled to take place at year end. The solution was simply to postpone them so that we can continue to live beyond our means, but averting the fiscal cliff simply worsened the fiscal crisis. If the US were a household, it would have $24k in income, $38k in expenses and $14k in debt being added each year to a balance totaling $164k. In Spain they call this insolvent. Our political leadership spent weeks bickering over whether to increase tax rates for those earning over 400k or $1 million per year, the difference amounting to a trivial $20 billion in annual revenue when we have deficits of $1 trillion.

With no legitimate deficit reduction plan presented to date that will stabilize our debt, consumers still face tax increases totaling $160 billion from increases in the payroll tax, the top marginal rate for high-income earners and a new healthcare tax. Despite this massive headwind hitting at a time when real income is already declining, housing remains fragile, employment growth is weak and corporate profitability is rolling over, the financial markets are indicating better days ahead.

A growing number of economists, strategists and politicos, in concert with the media, are reading into recent stock and bond market strength as a leading indicator that the real economy is also strengthening. This has been the master plan behind the Federal Reserve's quantitative easing (QE) programs, which are ongoing, and now being replicated in Europe and Japan. Understanding the mechanics behind this trickle-down monetary policy scheme helps explain the growing dislocation between economic fundamentals and market valuations, and the risks that are building as a result.

Chairman Bernanke continues to postulate that the Fed is now purchasing $85 billion of Treasuries and mortgage-backed securities each month to promote economic growth and stimulate employment by lowering interest rates and increasing the credit available in the banking system. He has also noted the positive effect this policy has had on the stock market, which he asserts will lead to a wealth effect that promotes consumer spending.

We see no connection between the Fed's debt purchases and credit availability, employment or economic growth. It has simply been a windfall for the banks. Outstanding loan balances for the three largest US commercial banks (JPMorgan (JPM), Wells Fargo (WFC) and Bank of America (BAC)) have been stagnant for three years-no growth in lending. Meanwhile, the Fed has infused nearly $900 billion in excess reserves on the balance sheets of just these three banks alone through QE. The Treasury issues debt to finance the deficit, which those banks that serve as primary dealers then purchase. The Fed purchases the Treasuries from the banks and gives them newly created dollars. What are they doing with them? We contend that they are investing these dollars (excess reserves) in high-quality securities (more Treasuries), and then using those securities as collateral to borrow additional capital through what is called repo financing. They are then speculating with the huge sums they borrow. The banks are only required to disclose to regulators what is being held as collateral, so technically they can say that they are not gambling with the excess reserves.

JP Morgan disclosed last June that it had reserves of $423 billion in excess of loans. It is no coincidence that it had approximately $323 billion in "available for sale securities" managed by its investment division. When this group lost more than $6 billion on a $100 billion derivatives trade in a scandal that hit last summer, it was very telling as to what these banks are doing with the liquidity provided by the Fed. It is not being lent. It is not creating jobs. It is not leading to economic growth. It is being used to speculate, manipulate and inflate the value of financial markets. Our markets have once again turned into a casino, but this time operated by the Federal Reserve, with our too-big-to-fail banks, now even bigger, serving as its dealers.

If the economic fundamentals were improving along with stock and bond valuations, then we might see the sensibility in Fed policy, but they are not. The wealth effect is having no impact on economic growth, because 90% of stock and bond wealth is held by the wealthiest 10% of Americans. The middle-class has no skin in the game. Valuations are rising as fundamentals are deteriorating, just as they did prior to the peak in home prices.

The same speculative investment activities that led to the expansion of credit that inflated home values are at work again today. The difference is that the Fed is providing credit to the banks, instead of the banks providing credit to borrowers. The banks are speculating in stock, bond and derivatives markets, instead of borrowers speculating in the real-estate market. The Fed continues to hope that a rebound in the market will have its desired effect on employment and economic growth.

We see the same experiment underway in Europe. The ECB, following the Fed's lead, has lent trillions of euros to European banks so that they can purchase the sovereign debt of insolvent EU member nations and prop up financial markets. The goal is to lower the borrowing costs of countries like Spain, Italy and Greece, thereby creating the illusion of economic stability. Despite these actions, the EU economy is back in recession. ECB President Mario Draghi, a schoolmate of Chairman Bernanke's, expects the economy in Europe to recover, noting that financial market improvements have yet to trickle into the general economy.

In the US, with our fiscal crisis worsening and our economy weakening, all of the financial market indicators that would be raising red flags have been deafened by monetary policy. Volume has collapsed on our exchanges. High-speed computer trading programs that provide all of the liquidity, yet have no responsibilities, account for the majority of what volume is left. Our largest financial institutions, now larger than they were before the financial crisis, are operating as unregulated hedge funds. Measurements of risk (volatility) in the stock market have fallen to levels not seen since 2007.

The herd mentality to chase performance is tantalizing right now. We are reminded of the euphoria over Apple (AAPL) stock, when at $700 per share it was the world's most valuable company. Over the past four months 35% of its market value has evaporated. We have no doubt that bullish sentiment for the broad market indices can vanish just as quickly. We know that dislocations can last for extended periods of time, as they have in recent months, but we do not want to play what looks like a dangerous game of musical chairs in hopes that we are able to grab a seat before the music stops. Quantifying the amount of principal risk in stock and bond markets is a difficult exercise, but we see it as substantial, and so long as the dislocation between fundamentals and valuations continue, that risk grows.

Our strategy continues to focus on maintaining significant liquidity in combination with precious metals (SLV, IAU), high-quality fixed income and modest exposure to income-oriented and emerging market equities. Targeting mid-single digit returns, while at the same time maintaining the liquidity necessary to capitalize on a bear market decline in stocks that does not imperil that return, is what makes the most sense to us as we begin 2013.

Source: 2013 Market Outlook: Optimism Must Be Grounded In Realism

Additional disclosure: DISCLOSURE: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Clients of Fuller Asset Management may hold positions in the ETFs mentioned above. Fuller Asset Management makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by the firm. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.