Successful chess players, such as Anatoly Karpov or Garry Kasparov, are world renown for their ability to think ahead and anticipate their opponent’s strategy. This kind of forethought not only harnesses the power of their own moves, it also protects them against an unexpected case of checkmate.

Few investors are stock market visionaries and no one is a ‘profit prophet’. Therefore, if you got blindsided by the 2007 – 2009 stock market meltdown, or if the 40% rally from the March lows caught you by surprise, BEWARE as your portfolio may be in line for yet another zinger.

Similar to investing, emotions can get in the way of playing a successful game. Chess legend Savielly Tartakower remarked that a chess game is divided into three stages. The first, when you hope you have the advantage; the second, when you believe you have an advantage; and the third, when you know you’re going to lose.

Since emotions are useless, even counter-productive when it comes to investing, it makes sense to analyze purely the facts to outline a strategy for the next sequence of moves.

Just a few days ago, Treasury Secretary Timothy Geithner observed that the stimulus is working and on the right path, while President Obama declared that the world has avoided disaster. Has it really?

The ‘Chicken or the Egg’ Question

True, the stock market is in rally mode. The question is whether stocks are rallying due to the stimulus packages' success, or if the stimulus packages only appear successful because stocks are rallying.

On March 18th, the Fed announced to buy $1.2 trillion worth of its own bonds. On March 23rd, Timothy Geithner announced the long-awaited Public Private Investment Program (PPIP) details. On both days, the stock market sold off. Nevertheless, credit for the ensuing rally was given to the effectiveness of the government stimulus.

In reality though, the Dow Jones (DJI: ^DJI), S&P 500 (SNP: ^GSPC), and Nasdaq (Nasdaq: ^IXIC) had bottomed nearly two weeks before the first announcement. By that time, stocks had already rallied between 16% and 20%.

Contrary to Wall Street, which was stuck in a wave of doomsday news, the ETF Profit Strategy Newsletter sent out a Trend Change Alert on March 2nd, recommending to buy long and leveraged long ETFs, since a 30 to 40% rally was about to sweep investors off their feet. As it turned out, this alert was only a few trading days early. Featured ETFs such as the Ultra S&P 500 ProShares (NYSEArca: SSO), Financial Select Sector SPDRs (NYSEArca: XLF), Ultra Financial ProShares (NYSEArca: UYG), and many others have gained 70%, 100%, 200% and more.

The Economic Picture Examined

At face value, certain indicators do seem to suggest that an economic recovery is under way.

Last week’s seasonally adjusted jobless claims for example fell 47,000 to 522,000.That’s the lowest reading of 2009. As it turns out, the seasonal adjustment paints the picture rosier than it actually is. The numbers before the seasonal adjustment read as follows: Initial jobless claims rose by 86,389 to 667,535. Continuing jobless claims rose by 65,000 to 6.14 million.

The unemployment numbers do not include the 'under-employed'; workers who had to take part-time jobs because no full-time jobs were available, or workers who have received unemployment benefits for more than a year. The self-employed masses, many existing on less than 50% or more of their prior income, are also conveniently omitted from these reports. The real unemployment rate is somewhere between 16 and 20%.

A look at the jobless numbers (initial, continuing and real) explains why borrowers with (once) prime credit now make up the largest percentage of mortgage defaults. Once the job is gone, you can’t pay your mortgage or spend money elsewhere.

A Self-Perpetuating, Downward Spiral

All of the above leads to depressed real estate prices. Even though real estate ETFs, such as the iShares Dow Jones US Real Estate (NYSEArca: IYR) or iShares Cohen & Steers Realty Majors (NYSEArca: ICF) have recovered nicely, actual real estate prices are still depressed. If you are trying to sell a house in this market, you know that showings are slow and offers are low, it at all.  Meanwhile, short sales and foreclosures maintain the lion’s share of business.

Just as a change in the smallest member of the food chain will affect the largest member, deterioration of personal income will soon stifle the economy. A decrease to plankton (nearly invisible to humans), will eventually affect the well being of 150 ton whales.

We, the consumers, are the financial plankton; banks and financial institutions are the whales. The “whales” are still suffering indigestion from a poor diet of toxic assets. The amount of toxic assets (bad loans) will increase as long as consumers lose their jobs and real estate prices fall.

Financial institutions will eventually feel the pinch. This will lead to a decline in share prices. ETFs like the Vanguard Financial ETF (NYSEArca: VFH) and iShares DJ US Financial ETF (NYSEArca: IYF) will exit the rally first. Small company stocks will be the first victims of tight credit. Watch for ETFs like the iShares Russell 2000 (NYSEArca: IWM) to cut out next. Real estate ETFs also will be one of the first sectors to head south.

This ripple effect will soon, thereafter, get a strangle hold on broad indexes like the MidCap SPDRs (NYSEArca: MDY), Dow Jones (NYSEArca: DIA), and S&P 500 (NYSEArca: SPY).

Right before that happens, as Savielly Tartakower described the second stage of a chess game, investors believe they have the advantage.

An increase in investor optimism is not only indicative for a market top, it is a requirement.  At the beginning stages of the ensuing decline, investors will still believe that the market will recover. After all, that’s what we’ve been conditioned to believe.

Not until it is too late, will Savielly’s third stages take hold; investors know they’re going to lose.

This forecast may sound scary, but it is completely supported by fundamental indicators with a history of historic accuracy. At every other bear market bottom over the past 100 years, dividend yields and P/E ratios have clocked in at rock bottom levels before giving the green light for the next bull market.

Just as ice doesn’t thaw until the temperature goes above 32 degrees, the market doesn’t rally for good unless P/E ratios and dividend yields reach certain levels. In fact, based on those reliable indicators, one can actually pinpoint a target range for a market bottom that’s here to stay.

How to Avoid Checkmate

The best way to avoid checkmate, is to avoid any situation that could be labeled as ‘check’. It requires forethought to always stay ahead of the market, by at least one move. Unless you prepare your portfolio for the next downturn, it could soon be in checkmate.

The brand-new issue of the ETF Profit Strategy Newsletter includes a detailed short, mid, and long-term forecast, along with target levels for the end of the rally. Levels for the ultimate market top, and 7 practical ways to survive and thrive in the coming years, are also included.