Investing is a lot like playing golf. One or two bogeys can void an otherwise decent round.
Investors surely have been racking up “investment bogeys.” Even though the past two months have lifted stocks and the spirit of many, the memory of the October 2007 – March 2009 carnage is still fresh.

Since the March lows, the Dow Jones (NYSEArca: DIA) rallied some 2,000 points, or 30%. This is in line with the ETF Profit Strategy Newsletter’s trend change alert which, on March 2nd, foresaw this rally to be the biggest one since the October 2007 all-time high with gains between 30-40%.

Even though there is some more room for this rally to develop to the upside, it has met the newsletter’s minimum requirements.  From here on out, investors should be aware that the downside risk is larger than the upside potential (more about that later).

The eternal  question – buy, sell or hold?

Until a few days ago, the higher risk (higher beta)  Nasdaq (Nasdaq: QQQQ) plowed ahead of the S&P 500 (NYSEArca: SPY)  by more than 5%. Over the past few days, the Nasdaq has slowed down. The weakness in higher beta indexes is often an indication that an advance is running out of steam, often considered a bearish non-confirmation.

This condition may last for quite a while. In fact, a pullback may re-align the short term technicals just enough to fuel one more final advance.

Regardless, now is the time to review your portfolio and decide which ETFs are dead  weight during the next leg down.

Similar to this article, the ETF Profit Strategy Newsletter had warned of another leg down in mid-December. Back then, the newsletter observed the following: “Optimistic sentiment, which should be more visible above Dow 9,000, will give way to further declines. These should draw the indexes below their November 21st lows and eventually below Dow 6,700.”

Extreme investor optimism, or pessimism, tends to signal a change in direction. The current 30%+ rally was born amidst the doomsday atmosphere surrounding the March lows. Conversely, the biggest bear market since the Great Depression started its reign at Dow 14,000, when financial stocks were the top performers and investors couldn’t be more optimistic about their future prospects.

The current rally has rekindled this optimism to a surprisingly large extent. Wall Street, along with stock markets around the globe, was quick to regain its confidence. The Wall Street Journal’s May 11th front page headline read: “World Regains Taste for Risk.” This should serve as a red flag for savvy investors.

Low tolerance for high octane

High octane funds like financial and leveraged ETFs will obviously get hit hardest by any sort of pullback. The Financial Select Sector SPDRs (NYSEArca: XLF), a basket of 81 financial companies, has rallied more than 115% over the past two months. The Ultra Financial ProShares (NYSEArca: UYG), a double leveraged financial ETF, is up about 210% in the same time-frame. Even the Ultra S&P 500 ProShares (NYSEArca: SSO), a double leveraged ETF linked to the S&P 500, gained over 80%.

Such high octane ETFs can rise or drop 10-20% in a single day. Taking profits at this time is a conservative move and surely no sin. Sometimes it’s simply better to forego some of the potential upside in return for protection against serious downside risks.

Keep in mind that most of the high yielding dividend ETFs has significant exposure to financials. The iShares Dow Jones Select Dividend Index sports, has a 25% stake in financials. Juicy dividends can cushion the fall, but will fail to even make a dent when the next leg down resumes.

Funds linked to any of the major benchmark indexes are next in line to be slated for liquidation. Once again, this does not have to be right away, but anyone adhering to savvy management principles should formulate an exit strategy now.

Such ETFs include the Dow Diamonds (NYSEArca: DIA), S&P 500 SPDRs (NYSEArca: SPY), iShares S&P 500 Index ETF (NYSEArca: IVV), iShares Russell 3000 ETF (NYSEArca: IWV), MidCap SPDRs (NYSEArca: MDY), and many others.

Is there safety in bonds?

Many find it hard to resist the allure of stock-like bond yields. The iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca: HYG) pays a juicy 11%. The iShares iBoxx Investment Grade Corporate Bond Fund (NYSEArca: LQD) pays 6%. Don’t allow yourself to be tricked by double digit yields or the “investment grade” label.

When the financial turmoil started, investment grade corporate bonds lost 20% within a matter of days. High yield and junk bonds did even worse. This might just be a glimpse of what the future holds for bonds. The same holds true for municipal bond funds such as the iShares S&P National Municipal Bond Fund (NYSEArca: MUB).

Many municipalities find themselves struggling as their tax revenue stream dwindles away. Falling real estate prices, closing businesses, and declining consumer spending has hurt most municipalities.

Are U.S. Treasuries safe?

Many believe that U.S. Treasuries are risk free. Over the past 30 years, U.S. Treasuries have morphed from investment wall flower to investment pop star. Even traders like long-term Treasuries.

In reality, Treasuries come with a fair shot of interest rate and issuer risk. Long-term Treasuries such as the iShares Barclays 20+ Year Treasury Bond Fund (NYSEArca: TLT) are most sensitive to interest rate changes. Yields on 30 year Treasuries have risen from 2.5% to over 4%. TLT has fallen nearly 30% over the past several months.

Short term government bonds, such as represented by the iShares Barclays Short Treasury Bond Fund (NYSEArca: SHV), reduce the interest rate risk. Nevertheless, all government bonds bear credit risk. Even though this might be a moot point right now, it will become more of an issue as the government continues to manipulate its financial stability.

How to profit

According to Federal Reserve Chairman Ben Bernanke, the recession is likely to end later on in 2009, banks are sound and the fundamentals have improved. President Obama and Treasury Secretary Tim Geithner were quick to agree that the worst is over.

Naturally, you might find it tough to argue with such credible sources. However, consider the following statement by the President, on the state of the union, to the reconvening Congress: “No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than which appears at the present time. You can regard the present with satisfaction and anticipate the future with optimism.”

It was President Coolidge who uttered the above words on December 4th, 1928 – less than a year before the onset of the Great Depression.

John Kenneth Galbraith, author of “The Great Crash,” put it this way: “Always when markets are in trouble, the phrases (coming from Washington) are the same: ‘The economic situation is fundamentally sound.’ All who hear these words should know that something is wrong.”

Just as the human body has a discernable alarm system, the stock market also possesses an internal warning system. This has proven to be much more accurate than any politician’s or Wall Street analyst’s forecast.

A fever thermometer lets you know whether the body is running hot or not. Long-term indicators such as dividend yields and P/E ratios serve as a fever thermometer for the stock market.

An analysis of historic market bottoms shows that the market does not bottom unless P/E ratios and dividend yields reach a certain level. Just as the body is not healthy unless it clocks in at 98.6 degrees, the stock market is not “healthy” unless those indicators clock in at certain levels.

The March issue of the ETF Profit Strategy Newsletter includes a detailed analysis of P/E ratios, dividend yields, the Dow measured in gold, and investor sentiment along with target levels for the ultimate market bottom and the end of this rally.