How is your canary? That’s an odd question you might say. Let me explains the significance of the “canary.”

To some, the canary may just be a cute, small songbird, while others trust him with their lives. British coal miners used the canary as an early warning system. Due to their sensitive system, the birds would show signs of distress if toxic gases, such as carbon monoxide and methane, were present. Their chirping (or lack thereof) would be the minors chance to get out of the mine before it was too late.

To this day, the term “canary in the coal mine” is used to refer to early warning indicators of a coming crisis. Canaries are as vital for coal miners as indicators are for investors.

After the three major U.S. indexes – S&P 500 (SNP: ^GSPC), Dow Jones (DJI: ^DJI), Nasdaq (Nasdaq: ^IXIC) – rallied between 50% - 70%, it might be time for a canary check? Is there danger in the air? Would your canary (= financial advisor, research, indicators, etc.) detect a poisonous environment for stocks? Was your early warning system working at the 2007 market top and 2009 bottom? If not, perhaps it’s time to replace your canary.

Leading the pack

China has been the dominant or alpha male of the global markets. China spearheaded the decline from the 2007 highs and rallied higher and faster from the March 2009 lows. This makes sense, as China is perceived to be the new manufacturing powerhouse.

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As such, China’s companies are particularly sensitive to economic cycles. The demand for “Made in China” is a sensitive indicator as it reflects developed market’s thirst for new product. Of course, the opposite is also true, a lack of demand should be felt by Chinese manufacturers first.

So what is this gigantic Chinese canary telling us? Since March, the iShares FTSE/Xinhua China 25 ETF (NYSEArca: FXI) has rallied more than 100%. The same is true for emerging market ETFs such as the Vanguard Emerging Markets (NYSEArca: VWO) and iShares MSCI Emerging Markets (NYSEArca: EEM). All three ETFs outperformed the broad measure of global developed markets, the iShares MSCI EAFE (NYSEArca: EFA).

As the chart below shows, the broadest measure of Chinese stocks, the Shanghai Composite Index, topped already in August, over a month before U.S. stocks reached their highs. The Shanghai Composite has been declining since.

The performance of Chinese stocks is consistent with the Baltic Dry Index (BDI). The BDI tracks worldwide international shipping prices of various cargoes. As the chart below shows, the decline in shipping rates has had a direct effect on Chinese stocks. Looking at the Chinese market, the canary detects danger.

Yes, U.S. stocks are overvalued

Even though the Dow Jones (NYSEArca: DIA) and S&P 500 (NYSEArca: SPY) are still 30% below their 200y high watermark, the indexes remain overvalued. There are different ways to ascertain a stock or stock market’s value. Simply looking at the current price isn’t one of them.

Would you say that a car for $10,000 is a better value than a car of $14,000? You can’t tell just by the price. The $10,000 car might be on old gas guzzling Ford Explorer, while the $14,000 car might be a newer Mercedes. It’s what’s behind the price that matters.

An analysis of the Dow from a few years ago, trading at around 14,000 with today’s Dow around 10,000 shows that Dow 10,000 – or stocks in general – are overvalued, based on what’s behind the 10,000 label.

A company’s earnings are what makes a stock cheap or expensive. High earnings validate a higher price and vice versa. Earnings for the S&P 500 are the lowest they’ve ever been. That’s why the price earnings ratio (based on reported earnings) has shot all the way up to 144 for the second quarter of 2009.

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The P/E ratio for financials (NYSEArca: XLF) is even higher than the S&P’s. In fact, financials are the second most overvalued industry sector, despite continuous concerns about banks’ health.

P/E ratios above 25 are commonly viewed as a signal that stocks are due for a correction. Now imagine what a P/E ratio of 144 signals. We’ll talk more about the crystal ball like features of P/E ratios in a moment.

Bonds, the “other stock”

Corporations have different options to raise money. Issuing bonds and stocks are two of them. Bonds are perceived to be safer as they are not subject to the stock market’s ups and downs.

Nevertheless, a liquidity crunch of the underlying company would severely hurt bond holders. To illustrate, General Motors, the world’s largest auto maker was hit hard by this economic downturn. Stock holders lost more than 95% of their money invested in GM. Bond holders lost up to 80 cents on the dollar.

The year 2008 provided a glimpse of what can happen with corporate bonds. Within a few days in October 2008, the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEArca: LQD) fell nearly 20%. The iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca: HYG) dropped 25%. Lower quality junk bonds did even worse.

“Canaries” for beginners

Just as a canary would be useless for a coal miner if left on top of the mine shaft, many indicators are useless to investors because they’re being misapplied. Indicators have to be viewed in context with the current market environment otherwise they might “misfire.”

Different statistics such as consumer spending, consumer sentiment, home prices, etc. are lagging indicators. As such, they provide a snapshot of what happened, not a prediction of what is to come. You don’t drive by looking in the rear view mirror, why invest that way?

In a March 2nd Trend Change Alert, the ETF Profit Strategy Newsletter predicted the biggest rally since the October 2007 all-time highs with a target range of Dow 9,000 – Dow 10,000. The end of this rally was to be marked by extreme levels of optimism.

The recent upticks in home sales, home prices, consumer sentiment, and consumer spending are all a manifestation of the higher prices and optimism foretold in the Trend Change Alert. As the chart below shows, consumer confidence (and upticks in most other statistics) increases with stock prices. It is probably safe to say that economic indicators increase because of stock prices. If stock prices fall, so will the economic indicators.

This is confirmed by forecasts of analysts and economists given over the past month or two. The yo-yos who never saw the recession coming, are now proclaiming the “The recession is over,” and every “guru” who’s been wrong on the market, is now saying “buy.”

The key is to be ahead of lagging indicators, economists and analysts. Once the aforementioned jump on the trend, it has usually come close to being exhausted.

The ETF Profit Strategy Newsletter used investor sentiment to issue a sell alert in January around Dow 9,000 and a buy alert in March around Dow 6,800. The time has certainly become ripe for another sell alert to be issued soon.

The extent of the fall

Based on sentiment readings and the intensity of the recent rally, the upcoming fall will be as deep as it will be surprising.

History tells us that stock markets only bottom once valuations are reset to rock bottom prices. With a P/E at 144, and the “E” (earnings) unlikely to grow, the only way to lower the ratio is by (significantly) lower stock prices. The 2002 bottom failed to properly reset valuations and we’ve seen what happened since.

This bear market won’t make the same mistake. Stock prices will hit rock bottom to restore P/E ratios and other valuation metrics – such as dividend yields – to the levels that truly define a major market bottom. The stock market has established a predictable pattern of how low P/E ratios and dividend yields will have to fall in order to “ring the market bottom bell.”

Based on those predictable patterns it is possible to calculate a target range for the ultimate market bottom. The ETF Profit Strategy Newsletter includes an analysis of historic market bottoms, along with a target range for the top of this rally and the ultimate market bottom.

If your canary has been asleep in the cage or left on top of the mine shaft, now is a good time to find a reliable early warning indicator. History suggests that we are at a major turning point for the U.S. stock market.