Look at this definition of a bubble (given by author John Kenneth Galbraith), and take a moment to look around and determine for yourself  how many bubbles you can see right now.

Definition: A bubble comes with rising prices. This increase attracts attention and buyers, which produces the further effect of even higher prices. Expectations are thus justified by the very action that sends prices up. The process continues; optimism with its market effect is the order of the day. Prices go up even more (John’s conclusion quoted in a moment).

Based on an avalanche of economical, fundamental, and historical data – not the type of data that caused Wall Street to miss the last four big bubbles (technology in 2000, real estate in 2005, equities in 2007, commodities in 2008) – you should be able to identify five markets ready to send portfolios for a tailspin.

No one wants to be caught at the wrong end of an exploding bubble, so caution is advised; as Benjamin Franklin put it, an investment in knowledge will pay the best dividends.

Even though not the popular consensus on Wall Street; a case could be made that the discrepancy between U. S. stock performance and the underlying economic fundamental has reached a point where the tiniest bit of bad news might act as the proverbial needle that pops the balloon.

The 45%+ rally in the Dow Jones (DJI: ^DJI), S&P 500 (SNP: ^GSPC), and Nasdaq (Nasdaq: ^IXIC) has certainly re-inflated the just deflated U.S. equity bubble, along with the egos of Wall Street and individual investors. Generally speaking, a bust occurs at a time when nobody expects it. That’s what makes it a bust; otherwise it would be an opportunity for most.

Bubbles have perfected the science of blindsiding naïve and gullible people. There are a number of parallels between today and 2007, even 1929. Are U.S. stocks about to blindside investors yet again? Before we talk about the U. S. market, we’ll address some more obvious extremes with the potential (even likeliness) to blow up big.

China

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’s (minimum) target of $750 billion.

We know that money makes the world go round, and this should be good news as governments globally have been trying to increase lending. But, wait a minute, is this really good news? Isn’t easy money what got 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.”

The fact that China’s bank chief is concerned about a bubble, indicates that the conditions (blindside) are not quite ripe yet for China’s stocks to blow up. If you hold the iShares FTSE/Xinhua China 25 (NYSEArca: FXI), or any other China ETF, you might be able to squeeze out more gains.

Out of precaution, the ETF Profit Strategy Newsletter, which predicted a 60%+ rally for Chinese stocks previously on December 11, 2008, just recommended locking in profits after a near 50% gain.

Emerging markets

With a 16% weighting in the iShares MSCI Emerging Markets ETF (NYSEArca: EEM) and 20% share in the Vanguard Emerging Markets ETF (NYSEArca: VWO), China is the biggest component of emerging markets investing. It is reasonable to expect the tidal wave of a China bust to be hitting other emerging markets, such as Brazil (NYSEArca: EWZ).

The component of surprise would certainly be present. VWO, EEM, and EWZ rallied between 80% - 90% from their March lows. About 70% into the rally, even the financial media realized that emerging markets are on a tear. The ETF Profit Strategy Newsletter, which called for a market bottom on March 2nd, said the following about Emerging Markets on March 16th: “While emerging markets should move in the same direction as developed markets, they offer more upside potential.”

Yes, more upside potential resulted in more gains which even resurrected talks about the decoupling of emerging markets (last seen early 2008), a classic symptom of a bubble in its final stages. Considering that emerging markets have been crowned the leader of the “new economy”, an imploding of emerging markets stocks is quite possible, even likely.

Inflation protected bonds

Inflation vs. deflation has been one of the most heated debates of 2009, and for good reason.  If you prepare your portfolio for the wrong environment, your financial life will most certainly suffer. This is one call you can’t afford to get wrong.

It is true that the government’s money printing machine is inflationary in nature. However (and that’s a big however), for money printing to be inflationary, two things absolutely have to happen:

1) Banks need to lend money. So far, banks have used the funds received to repair their own balance sheets, hording it so to speak. Most of the freshly printed money doesn’t even make it into the economy, thereby denying its inflationary properties.

2) The overall money (or credit) supply needs to increase. For that to happen, the amount of new money coming into the economy needs to outpace the amount of money leaving the economy. The 2007 – 2009 bear market has already destroyed more than $15 trillion of U.S. credit (money leaving the economy). So far, the Fed has only added $2 trillion to the economy. Imagine trying to fill a barrel that has a giant hole. It would take several fire hoses just to keep the water level stable. As long as the hole (unemployment, consumer credit, property values, etc.) doesn’t get fixed, throwing water (money) at it won’t help.

For a more detailed analysis, consider the article: Deflation or Inflation: What’s the true enemy?

Even though inflation protected bond funds, such as the iShares Barclays U.S. Treasury Inflation Protected Securities Bond ETF (NYSEArca: TIP), have been on the rise, their performance should soon reflect that inflation is not the true enemy.

Commodities

Commodities are often viewed as a hedge against inflation. But, what if inflation doesn’t happen?
Recent reports by the Wall Street Journal and Bloomberg.com confirm what the ETF Profit Strategy Newsletter has been saying all along; the current U.S. recession is the worst since the Great Depression.

As such, it behooves us to take a look at what happened during the Great Depression. Many may link the hyperinflation in the German Weimar Republic to the Great Depression. This is not true, since the spout of hyperinflation occurred from 1921 – 1923, years before the 1929 – 1932 melt down in equities.

During this four-year deflationary meltdown, which came to be known as the Great Depression, ALL asset classes lost value, including commodities. Even Rockefeller’s Standard Oil, an oil/energy company, lost over 70% of its value.

Commodities and broad commodity ETFs, such as the iShares S&P GSCI Commodity ETF (NYSEArca: GSG), will not provide shelter in a deflationary environment. The only asset class which will provide protection eventually is gold (NYSEArca: GLD). Nevertheless, the persistent public insistence on the current merits of gold suggest that a decline in prices is due before the real value emerges.

U. S. stocks / financials

Investors are more bullish than they’ve been in over a year. The American Association of Individual Investors recorded the biggest bullish spread since May 2008, parallel to the S&P 500 (NYSEArca: SPY) moving above 1,000 for the first time in 2009.

Ironically, the investing crowd tends to get bullish only after most of the gains have already been seen. That’s why savvy investors use this and other sentiment indicators as a contrarian tool. As the bullish crowd grows, so does the chances of a market reversal.

In the March 2nd Trend Change Alert, the ETF Profit Strategy Newsletter foretold that this extreme of investor sentiment (bullishness), would be seen towards the end of a powerful 40% rally. In fact the top of this rally, a counter trend rally, would be marked by a “the worst is over attitude” which is exactly what can be observed today.

Similar to 2007 – when nobody expected the upcoming storm – financials (NYSEArca: XLF) and real estate (NYSEArca: RWR) should lead the charge towards the downside and send broad index like the Dow Jones (NYSEArca: DIA) to new lows. Judging by the degree of optimism present today, the move to the downside will be quite powerful and will leave many – just like in 2007 and 1929 – stunned.

The most recent issue of the ETF Profit Strategy Newsletter contains a target range for the top of this rally, along with a target range for the ultimate bottom and practical ways to thrive and survive in the upcoming years.

John Kenneth Galbraith, the author mentioned at the outset of the article, concludes his observation about a bubble as follows: “The descent is always more sudden than the increase; a balloon that has been punctured does not deflate in an orderly way.” He furthermore states that, leading up to the disorderly deflation, is the fact that there is more money flowing into the stock market than there is intelligence to guide it. Savvy investors will make sure they don’t become another casualty of repeated history.