Wall Street and the CIA are two of the most dangerous intelligence operations in the world. But despite having eyes and ears on the ground practically everywhere, they both get blindsided time and again.

How, for example, could the CIA let somebody whose father outed him as a Muslim radical board a plane bound for Detroit with gunk in his junk?

And how the heck could Wall Street not see how the banks were making crazy mortgage loans that were bound to end up in tears?

The answer: Both the CIA and Wall Street get too much information.

In a recent Boston Globe article on the CIA, Robert Jervis says, “The blackboard is filled with dots, many of them false, and they can be connected in innumerable ways. Only with hindsight does the correct pattern leap out at us, and to fix what ‘broke’ the last time around only guarantees you have solved yesterday’s problem.”

But, Jervis explains, yesterday’s problems aren’t necessarily tomorrow’s. And the same thing can be said about Wall Street.

It’s All In Your Mind

The way we interpret the information we get about the market has to do with how we think.

For one thing, we’re great at quickly putting patterns together and culling meaning out of seemingly random events. But that leads to “premature cognitive closure” – ignoring information that might disprove the patterns we see. So, for example, if you’re a bear you may dismiss the fact that home-building permits are up. If you’re a bull you may chalk up the fact that retail sales dropped in December to bad weather.

Second, we’re likely to ignore information generated by the absence of something expected. In a famous Arthur Conan Doyle story, only the extraordinary Sherlock Holmes saw that an important clue in the case was a dog not barking.

So who’s not barking? How about the consumer? The Conference Board Consumer Confidence Index increased in November and again in December. Of course, because of “premature cognitive closure,” that’s more meaningful for bulls than for bears.

Third, our conclusions about the market often rest on assumptions we can’t easily test or prove. For example, we assume that the more than $12 trillion thrown into the global economy by stimulus-spending governments will lead to rising prices. And, in fact, that assumption has already caused asset prices to rise.

It wasn’t an unreasonable assumption. But because the government is not tracking key money-supply data, it’s hard to prove or disprove.

Jervis says, “Our minds are very good at forming a coherent picture, but less good at challenging it, questioning its assumptions, and coming up with alternative explanations. We are quick and often assured, but we are not self-correcting.”

When Funds Shout “Sell!”

Professional investors, like fund managers, often correct after the fact. IDE’s Steve McDonald says they get it wrong so often – or get it right so late – that you’re better off following what he calls the mutual fund sell signal: “When funds start buying, you can be sure a top isn’t far off. You should sell. And when they sell, it’s an early signal that a market is bottoming. You should be buying.”

Steve says, “Over the past six months, small investors through mutual funds have been pouring money into emerging market and bond mutual funds, just in time for a sell off!”

Steve’s right. The results of a recent poll of professional investors and economists made it clear that Wall Street is already setting its sights on other markets. Soon you’ll see mutual funds pulling up stakes and rolling into those markets, with bigger and bigger amounts eventually signaling when those markets, too, are topping.

“It’s the fifth or sixth time in the last 20 years I have seen this happen. It’s a predictable trend,” says Steve.

The Next Favored Markets

According to a recent Bloomberg poll, professional traders and economists are developing a dislike for China, Europe, and Japan. And they’re beginning to like (drum roll, please)… yep… the U.S.

We should take these polls with a grain of salt. Wall Street could once again be getting cornered by its own assumptions. For example, is China really in trouble?

We’re not oblivious to the dangers of an overheating economy or the damage that big swings in “hot money” can visit upon a market. In a 2009 Congressional Research Service Report titled China’s “Hot Money” Problems, the authors write, “Many economists maintain that the rapid outflow of ‘hot money’ first from Thailand and then from other Southeast Asian economies was a significant contributing factor to the onset and severity of the East Asian Financial Crisis of 1997.” [my underlining]

What’s worrying the Chinese government is not the exodus of “hot money,” but too much of it coming in. The fact is, about $30 billion a month of “hot money” is still expected to flow into China during the first half of this year. That’s not much less than the $400 billion in “hot money” that flowed in between April 2007 and March 2008, when the country was flooded with investment dollars. China has every right to be worried.

Bankers Being Bankers

In response, China is cracking down on the banks. Makes sense. On the other side of the globe, the U.S. government is also attacking the banks.

But Obama is attacking the banks for lending too little. And China is cracking down on them for lending too much.

Same root cause, though: bankers being bankers. In both countries, the banks are undermining economic recovery by looking out for number one. They just go about it differently…

In China, bankers make their money by lending. They get an “off-the-books commission” for making the loan or they help their brother-in-law get a piece of the resulting business.

In the U.S., all that cash banks are sitting on goes into bonuses rather than loans. Either way, the results are the same – derailing economic recovery for personal enrichment. Nice to know bankers are the same wherever you go, huh?

Doing the Right Thing at the Right Time

I like what China is doing. So does IDE’s Ted Peroulakis. “China’s adjustments now are well-timed and appropriate,” he says. “Most important of all, they’ll prevent China from having to slam the brakes on growth down the road. That’s the last thing China wants. If only the U.S. could begin taking some tightening measures now before it’s too late and inflation gets going. But that’s too much to ask in an election year!”

The less-than-5% market correction following a 26.4% rise in the market from September 2009 seems reasonable under the circumstances. China has gone through much more extreme gyrations than this.

More Growth on its Way

How about the U.S.? The market still has legs, says our own Bob Irish. “Our echo boom so far has lasted 10 months… right on the average. However, our surge since the bottom is just 67%, well below the 90% average. This sug­gests the market has quite a bit of upside left before a correction.” In the current issue of Sound Profits, Bob also talks about the six big trends that are sure to make investors the most money in 2010.

We Said It First

Two weeks ago today, Ted Peroulakis told subscribers to his Options Power Trader that Goldman Sachs “could be negatively affected by impending legislation.” Yesterday, in the Financial Times, billionaire investor George Soros said, “If the legislation were carried through, it would certainly mean the end of Goldman Sachs as we know it.” I’m not criticizing Soros (a fellow London School of Economics alumnus) for being a little behind the curve. It happens to the best of us.

Invest Safely,

Andrew Gordon

Investor’s Daily Edge