How do fish get caught? They trust the bait and open their mouth. How do investors get burned? They trust the market and buy into it.

Obviously, for most of the time owning stocks is as important for a portfolio’s growth as eating for a fish’s survival.

However, there is a time to be cautious. When the waters are infested with fisherman and bait, it’s better for the fish to go hungry for a while. Even though not every potential meal is bait, keeping its mouth shut will ensure not getting caught.

Courtesy of the recent rally, investors who didn’t bail on stocks earlier this year enjoyed a feast of profits. The Dow Jones (DJI: ^DJI) and S&P 500 (SNP: ^GSPC) gained over 50%, while the Nasdaq (Nasdaq: ^IXIC) is up nearly 70%.

After predicting a bottom below Dow 6,700 earlier in 2009, the ETF Profit Strategy Newsletter foretold this massive rally from the March lows via the March 2nd Trend Change Alert. At the time, Dow 9,000 – 10,000 was given as a target.

What goes up must come down. The easy profits are over and with the Dow hovering near the magical 10,000 mark, odds are much higher that today’s bargain may turn into tomorrow’s money pit.

The perception that an economic recovery is at hand with higher stock prices on the horizon, is baiting investors into owning (more) stocks, funds, and ETFs. Who wants to be left behind when the market rallies?

The wrong question

Even though it may seem foolish considering the hopes stirred up by Dow 10,000, now might be the time to be more concerned about a change of trend than being left behind by the current trend.

When can you recall stocks jumping 55% in seven months without a major correction?

How often can you pinpoint stocks jumping 55% in seven months - despite 2.5 million new unemployment claims - without a major correction?

When was the last time stocks jumped 55% in seven months – despite a P/E ratio of 138, the highest ever – without a major correction?

A bait-and switch of historic proportions

How often … the list goes on, but its core is this simple fact: aside from the biggest sucker rally (1929 – 1930) seen during the Great Depression, there has never been such a fierce rally that defies all conventional wisdom.

Even though investors would like to ignore the issue of overvaluation and continue the party, the stock market has a memory like an elephant and will make sure this very issue will not be forgotten.

In fact, if the market’s past track record remains intact, this rally is a bait-and switch trap of historic proportions.

But what about better than expected earnings results

Even though the bar for earnings estimates to be beaten has been set very low (like telling a straight A student that a C is now acceptable), the actual earnings reports have been predominantly positive – in other words, earnings have adjusted to the “new normal” of slower declines.

Nevertheless, Wall Street believes that higher profits (EPS) are a strong signal for a true turn around. This is not so.

As the chart below shows, earnings per share (EPS) match the performance of the stock market at best, and are a lagging indicator at worst. We do know for certain, however, that positive earnings reports are not a leading indicator.

Using earnings as a forward looking indicator is like issuing a ten-day weather forecast based on a glance out of the window.

ETFs you shouldn’t own

Based on a reliable set of common sense indicators (more about them in a moment), the stock market will have to fall hard to reach fair valuations. Based on a number of short-term indicators, this rally has come within striking distance to its point of exhaustion.

Banking and financial stocks have rallied 130% on average since the March lows. This makes them one of the most overvalued sectors around. The Financial Select Sector SPDRs (NYSEArca: XLF), SPDR KBW Bank ETF (NYSEArca: KBE) and other financial funds are likely to fall harder and faster than most other sectors.

Due to a falling dollar and rising commodity prices, the otherwise boring materials sector has tagged on over 80% since the March lows. This makes the Materials Select Sector SPDRs (NYSEArca: XLB) and commodity ETFs such as the PowerShares DB Commodities ETF (NYSEArca: DBC) risky funds to own. If you think that commodities will provide a protection against inflations, you might be interested to know that ALL asset classes, including commodities, lost value during the Great Depression.

Smaller companies with small cash reserves will suffer most from a resumption of the liquidity crunch. The iShares Russell 2000 (NYSEArca: IWM), MidCap SPDRs (NYSEArca: MDY) and other small and mid cap funds should show signs of weakness before the blue chips.

Even though they won’t lead the way, broad indexes such as the Dow Jones (NYSEArca: DIA), S&P 500 (NYSEArca: SPY) and Nasdaq (Nasdaq: QQQQ) will have to see lower prices.

Of course, leveraged ETFs such as the Ultra Financial ProShares (NYSEArca: UYG), Ultra S&P 500 ProShares (NYSEArca: SSO) and many others will drop twice as fast as your average fund.

How low can it go?

With no correction deeper than 6-7%, the market has spoiled investors over the past seven months. The last time we’ve seen such suspiciously consistent performance was in 2007.

Based on four common sense valuation metrics with an outstanding track record of accuracy, stocks will have to fall much further to reach a level that is consistent with other bear market bottoms.

Historic market bottoms see P/E ratios drop to multi-decade lows, while dividend yields spike to multi-decade highs. Right now, P/E ratios are at all-time highs, while dividend yields hover near all-time lows, the opposite of what you’d expect at a market bottom.
In addition, the Dow measured in the only true currency – gold – has lost much more value than the Dow measured in dollars. Eventually, the dollar-Dow will follow the gold-Dow.

Cash reserves by mutual fund managers are still near all-time lows. Major market bottoms over the past 70 years have always coincided with abnormally high cash reserve levels. Yes, as investors in general, even fund managers are in cash at times of a market bottom and invested to the max at times of a market top.

Based on those four indicators, it is actually possible to calculate a target range for the ultimate market bottom. Indicative of the implications, we’ve dubbed those indicators the “Four Horsemen.”

The November issue of the ETF Profit Strategy Newsletter contains a detailed analysis of the four horsemen, along with a target range for the ultimate market bottom and a target range for the end of this rally.

How does a fish get caught? It opens its mouth when it shouldn’t. How do investors get burned? They remain invested when they shouldn’t.