“Fool me once, shame on you; fool me twice, shame on me.” Yet another chapter of the love-hate relationship saga between investors and the stock market is about to be concluded … and it won’t end with “they lived happily ever after.”

Investors, obviously, are forgiving people. Within a period of 18 months, the S&P 500 (SNP: ^GSPC), Dow Jones (DJI: ^DJI) and Nasdaq (Nasdaq: ^IXIC) reduced investors’ portfolios by over 50%. At that point, most hated the market.

After showing some good will for a comparatively short five months (March – July 2009), investors are once again falling in love with the stock market. Like a crafty mistress, the market has investors wrapped around her finger. As far as relationships go, the market’s recent shenanigans compare to making up for an act of infidelity with a bar of chocolate, a gross imbalance.

But it doesn’t stop here. Investors are starting to fall for the same tricks that shaved 50% off their wealth last time … “fool me twice, shame on me.”

2007/2008 all over again?

On June 8, 2007, Merrill Lynch’s midyear 2007 global economics report titled; “Global decoupling: A marathon not a sprint” predicted that “the global phenomenon of a decoupling between the economies of the United States and the rest of the world is becoming more pronounced and is set to last.”

Initially, this forecast proved to be true. US stocks topped early October 2007 while emerging market stocks continued to rally for several more weeks. From August to November 2007, the Vanguard Emerging Markets ETF (NYSEArca: VWO) and iShares MSCI Emerging Markets ETF (NYSEArca: EEM) outperformed the S&P 500 SPDRs (NYSEArca: SPY) by over 30% and developed market index ETF, such as the iShares MSCI EAFE ETF (NYSEArca: EFA), by over 25%.

It didn’t take long, though, before U. S. and most other developed markets joined forces with emerging markets to stage a synchronized descent to frightening levels.

Fast forward two years, and you’ll find that the performance numbers of emerging markets have captured investor’s attention. Once again, emerging markets are outperforming U. S. markets by a margin of 30% (since the March lows). The iShares Emerging Markets ETF (NYSEarca: EEM) is up 43% for the year. Looking for greener pastures abroad, investors have poured nearly $11 billion into, EEM making it the fourth biggest ETF in the world.

The last time investors found a 'greener pasture'; it happened to be over a septic tank, as the countries making up the emerging market segments lost over 70% (see chart below). Have the fundamentals changed?

The biggest constituents of the emerging markets index are China (16.32%), Brazil (14.76%), Korea (11.32%), and Taiwan (10.74%). As of recent, China has been singled out to be the bull markets next forerunner.

Emerging markets four months ago

Previously on December 11th, the ETF Profit Strategy Newsletter uncovered an opportunity in China. At the time, the Shanghai Composite was down 60% for 2008. Observing that the Shanghai composite broke out of an eleven month trading channel, the newsletter recommended buying China-related ETFs such as the iShares FTSE/Xinhua China 25 (NYSEArca: FXI).

On March 16th, the ETF Profit Strategy Newsletter commented as follows: “Similar to the U.S., many markets around the globe are in a bottoming process. While emerging markets should move in the same direction as developed markets, they offer more upside potential. Vanguard's Emerging Market ETF is probably the best in class emerging markets ETF.” Emerging markets have gained nearly 30% since.

Getting whipsawed by good news?

With an increase of $120 billion in new loans, the Industrial and Commercial Bank of China recorded its fastest loan growth year ever. Since the beginning of the year, all Chinese banks combined granted a record $1.1 trillion in new loans. This is nearly 25% of China’s annual GDP and more than the full year (minimum) target of $750 billion.

Money makes the world go round and it’s exactly this kind of news people were looking for to identify a new bull market. But wait a minute, is this really good news? Didn’t easy money get us into the 2007/2008/2009 bear market?

Even Liu Mingkang, the head of China’s Banking Regulatory Commission urges; “We must control the risk of real-estate loans.” As reported by Reuters. Mr. Mingkang further warned: “In the first half of the year, our country's banking loans expanded rapidly and helped play an important role in stabilizing the economy, but the loans growth has led to accumulated risks also increasing.”

If you own, or are thinking about buying emerging market funds, you should ask yourself the following:

1) Does the upside potential (after a 75% bounce from the March lows) really outweigh the risk of getting whipsawed?
2) Can a collapsing credit based financial economy be fixed by providing more credit (would you cure a frost bite with ice cubes)?

Until the rally from the March lows, global bailouts were considered a failure. Since stocks have rebounded, bailouts – especially China’s stimulus package – are viewed more favorably.

A chronological examination, however, shows that stocks bottomed before the last major bailout (Public Private Investment Program) and bank stress tests even went live. As early as November 2008, the ETF Profit Strategy Newsletter predicted that a bottom below Dow (NYSEArca: DIA) 6,700 would be followed by a massive rally. A Trend Change Alert, highlighting that the biggest rally in years is imminent, was sent out on March 2nd.

A different type of “decoupling”

The lack of sustainable earnings, continually high unemployment numbers, falling real estate prices (despite higher sales), deteriorating consumer credit and reliable long-term indicators (more about those in a moment) point towards a resumption of the bear market.

What about the “good news?” Today good news is abundant, but doesn’t a rising market always give birth to good news and increased investor optimism? News reports are a snapshot of current events, not a preview. As such, positive news reports always increase towards a market top and vice versa.

Emerging market stocks and ETFs, such as the iShares MSCI Brazil (NYSEArca: EWZ), iShares MSCI Taiwan (NYSEArca: EWT), SPDR S&P 500 BRIC ETF (NYSEArca: BIK), SPDR S&P Emerging Markets ETF (NYSEArca: GMM) and many others, are riding the wave of positive perception. This wave is about to hit the shore of reality.

While some individual country ETFs quite possibly will be able to buck the trend, global markets will soon join the resumption of this bear market, as they did in 2007/2008. The only version of decoupling to be found; is a decoupling from investors and their portfolios.

A concerted decline, why?

In terms of magnitude, the only bear market that compares to the current one; is the Great Depression. The Great Depression was no local phenomenon, it was a worldwide event. Even though the current enthusiasm curtails certain data to circulate widely, here are some parallels between today and the Great Depression:

- Industrial production over the last nine months has been as bad, if not worse than the nine  months following the 1929 peak.
- The world stock markets have fallen even faster this time around compared to 70 years ago.
- The volume of world trade is drying up at a faster pace than the Great Depression
- Government surpluses are the lowest since the Great Depression

The bottom of the Great Depression (and every major bear market thereafter) was marked by P/E ratios, dividend yields, and mutual fund cash reserves reaching extreme levels. Just as ice does not melt unless the temperate moves above 32 degrees, a new bull market cannot start unless those indicators clock in at certain levels – which will be far in the distance.

The most recent issue of the ETF Profit Strategy Newsletter targets a range for the end of this rally and the ultimate market bottom, along with an analysis of long-term indicators and their implications for our future. Don’t give the market a chance to fool you twice.