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There is a bulldozer called reality that is in the process of leveling a house of perception that stands in its path. The Federal Reserve is the architect of this $2 trillion structure, and the ongoing maintenance cost is $85 billion per month. This house was built on a faulty foundation of paper profits and artificially depressed interest rates, rather than on rising incomes and capital investment, in the hope of convincing us that economic conditions are improving on a sustainable basis. In an effort to perpetuate this false perception, while at the same time weaning the financial markets off of the ongoing maintenance costs, Chairman Bernanke outlined the Fed's gradually improving economic outlook. Should this come to pass, it would allow the Fed to begin tapering off the rate of bond purchases as soon as this fall. Financial markets ignored both the conditionality of the tapering and the Fed's economic optimism, as stock and bond markets tumbled.

Stock and bond prices did not decline last week because investors feared that a lessened monetary stimulus would no longer be supportive of the overall economy, as the media widely reported, but rather because it will be far less supportive of the leveraged speculation in financial markets. What we have seen over the past month is the unwinding of that leveraged speculation that is the result of too much liquidity in combination with interest rates that were well below what the free market would otherwise have dictated. It was enabled and encouraged by misguided monetary policy. Investors fear that the music is about to stop, so everyone is grabbing a chair at the same time. As institutions deleverage, and individual investors realize short-term losses on their bond fund investments, those investors sell. Individuals pulled more than $17 billion from bond funds in the first two weeks of June. This leads to more deleveraging, which is followed by more retail bond fund outflows - a negative feedback loop that has driven 10-year Treasury yields to 2.5%.

The pillars of progress that the Fed is leaning on as the basis for its overly optimistic economic outlook are nothing more than a byproduct of the higher stock prices and lower interest rates that monetary policy has instigated with its asset purchases. As a result, these pillars are merely mirages that will vanish as stock prices decline and interest rates rise. Then the so-called progress will be undone.

The increase in home sales and home values over the past 18 months has predominately been a function of the decline in mortgage rates. It has not been a function of rising incomes. Therefore, the recent surge in mortgage rates above 4% is likely to result in a decline of new and existing homes sales, and a decline in home prices on a month-over-month basis. The most recent mortgage application report showed a 3% slide in loan requests for home purchases, which is the fourth weekly decrease in the past five weeks. Progress in the housing market is not sustainable without a commensurate rise in incomes.

It has been argued that low interest rates in combination with the increase in housing and stock market wealth has allowed consumers to dramatically reduce their financial obligations in relationship to disposable income. This perceived improvement is another pillar expected to fuel consumption moving forward. This may be true for a minority of wealthy consumers, but in reviewing the most recent report on household debt service payments and financial obligations as percentage of disposable income, there is a striking contradiction to this widely held belief. In the first quarter of 2013 the debt ratio for renters rose again to what is now the highest percentage (24.46%) since the fourth quarter of 2009. Therefore, with real wages declining and the savings rate a negligible 2.5%, consumption will be dependent on a continued increase in net worth.

In what is viewed by the Fed as another pillar of economic strength, household net worth rose by $3 trillion in the first quarter of this year to a record $70.3 trillion, driven by the rise in real estate and financial market valuations. The problem with this pillar is that these gains are concentrated within a very small demographic of consumers who are more inclined to save and invest those gains, rather than spend them. Entertain for just a moment the thought of Lloyd Blankfein shopping at a Walmart. The aggregate net worth of everyone in that store would soar, and average household net worth would well exceed $1 million. Regardless, at the end of the day the total sales receipts would not be measurably higher than they would have been if he shopped at a Tiffany's instead. Additionally, if financial markets decline and the rise in real estate values stalls, then the rate of increase in consumption due to this gain in household net worth is likely to fall. The only sustainable increase in consumer spending results from a rise in real incomes.

The Fed blames the slow recovery on fiscal policy, claiming that measures taken to shrink the deficit are reducing the rate of economic growth by as much as 1.7%. This may be true, but the mountain of money created by the Fed has led to little more than a molehill of credit available to those who need it, while the majority of that credit has been misallocated into market speculation, rather than productive innovation. The real beneficiaries have been corporations and the wealthy, leading to what has become an hourglass economy. It continues to increase in size at the very top, as well as on the bottom, while thinning in the middle day after day. This is not the foundation that leads to sustainable economic growth.

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The greatest injustice allotted to individual investors by the Fed's asset purchase program is that it has destroyed the pricing mechanism that exists in a free market, as in free from manipulation. The knowledge that comes from years of investment experience results in an understanding how markets typically respond to different and changing economic circumstances. Market prices serve as a compass for astute investors in that they act as a guide to help navigate the real-world economic developments that are likely to transpire moving forward. The Fed broke this compass when it twisted what used to be a discounting mechanism into what it hoped would be a catalyst to economic growth. That economic growth never materialized. As a result, markets have been sending misleading signals to investors. This makes stock and bond market performance the greatest money mirage of them all. If and when the performance erodes, it will topple each of the pillars of economic progress that have defined this slow recovery.

Everyone wants a prediction, so here is mine. I believe the S&P 500 (NYSEARCA:SPY) will test its 200-day moving average of approximately 1500 in the short to intermediate term. This would be a mere 10% correction from the highs. Subsequent to that, I see a high probability of the S&P 500 falling within the range of 1350 - 1400. This would bring the market within striking distance of a bear market decline of 20%. Regardless of how steep the decline, should it occur, I expect to see a rotation in sector leadership from defensive to cyclical names. In my view, there are already opportunities presenting themselves in what has been a mere 5% decline from the recent highs. I am looking for relative strength in the names that I want to own at current or lower levels as the broad market declines. Those companies that outperform tend to lead in an eventual broad market recovery.

Could the market fall substantially below the 1350 level? It certainly could, but what investors must realize is that the unprecedented amount of liquidity that exists today in the financial system is going nowhere anytime soon. It will support asset prices to some degree at lower levels.

I expect developing markets (NYSEARCA:VWO) to trough in advance of the U.S. stock market, and the pattern whereby developing markets lead developed markets to be reestablished. Based on consensus expectations for economic growth, the economies of Brazil, Russia, India and China, also known as the BRICs, will collectively eclipse the U.S. and Japanese economies in terms of size within the next decade. These countries, in concert with the rest of the developing world, are the engines of global growth. Their equity markets are flirting with levels we last saw in 2009, and I believe they present far greater value long-term than what I see in the broad indices of the U.S., Europe and Japan. Still, there are many headwinds confronting developing markets; therefore, a gradual approach to building positions is prudent.

I expect to see long-term interest rates, using the 10-year Treasury yield as a benchmark, to fall back below 2% later this year, before we see an eventual increase to 3%. As economic growth falls well short of consensus estimates, and equities continue to correct from current levels, yields should reverse their recent upward spiral. Therefore, there is significant value in the U.S. bond market at current levels. The rise in rates is not a result of expectations for higher rates of economic growth or inflation, but due to the unwinding of leverage by institutions that fear an end to the yield-compression policies of the Fed drawing nearer. The best defense for bond investors, in the event that rates do rise to 3% from current levels, is to own a combination of variable-rate securities and individual issues of fixed-income securities that have maturity or call dates in lieu of open-ended bond funds that do not mature.

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I have been expecting the crossroad in this bull market to be the point at which the stock market indices began to fall in the face of continued quantitative easing, breaking down the tight correlation between stock market performance and asset purchases depicted above. We are at that crossroad. The bear market decline in Japan's Nikkei index over the past month has proved that QE does not bulletproof a bull market. Those investors who did not succumb to the Fed's yield-compressing policies by eliminating cash balances from investment portfolios in search of any yield they could muster will soon be rewarded.

Source: The Fed's Money Mirage

Additional 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 securities mentioned in this article. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. 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.