A scholar once said: “To be prepared against surprise is to be trained. To be prepared for surprise is to be educated.”

Seasoned investors will tell you that decoupling your emotions from your finances is one of the prerequisites to prepare against surprises. This is easier said than done. Being swept up by the predominant emotion of the present is as common as it is natural (more about that later).

Adequate education provides the equilibrium needed to balance against the inevitable display of emotions. If your mind is not informed and educated about what might happen, odds are the market will throw you a curve ball and surprise you, intellectually and emotionally.

Contrary to what many think, emotions dictate investment decisions even more than education and research. In fact, there is one simple emotional trick that will prevent major investment faux pas (more about that later).

Because of the current state of the U.S. economy, however, we will start our discussion by identifying major economic stumbling blocks from an intellectual point of view.

Real estate – a dormant time bomb

Robert Toll, the CEO of Toll Brothers, one of the nation’s largest luxury home builder stated that the Federal Housing Authority’s (FHA) lending practices are a definite train wreck that will raise a red flag within the next couple of months.

The FHA finances homes with as little as 3.5% down. The FHA insured almost 1 of every 4 loans in 2009. 456,000, or 17%, of all FHA loans were in default as of September 2009. Independent audits show that the FHA’s reserves have fallen to $3.6 billion compared to $685 billion in outstanding loans. That’s a ratio of 0.53%, far below the 2% threshold required by congress.

Keep in mind that Robert Toll is a man who has a vested interest in real estate recovery and an end to the mortgage crisis. His outlook is truly alarming for anyone who’s not prepared for another real estate related setback.

This, however, is not even the biggest threat. According to Sheila Bair, chairman of the Federal Deposit Insurance Corp. (FDIC), souring commercial real estate loans pose the biggest threat to the U.S. banking industry.

Unpaid loans on malls, hotels, apartments and home developments reached a 16-year high in the third quarter of 2009.  These delinquencies are expected to continue rising throughout 2010 and 2011, as more than $1 trillion worth of commercial mortgages are set to renew.

This wave of upcoming, probably defaulting, mortgages poses a huge threat for regional banks (NYSEArca: KRE), which are almost four times more concentrated in commercial property loans than the big banks (NYSEArca: KBE).

The fact that the FDIC is having trouble finding buyers for many of the more than 120 banks it seized in 2009, is a testament to the poor shape banks are in.

Toxic mortgages were the cause of the post 2007 meltdown, as such it behooves investors to watch the developments in this sector closely. No recovery can take place until real estate prices recover. Don’t be fooled by the solid performance of real estate ETFs, such as the iShares Dow Jones US Real Estate (NYSEArca: IYR), SPDR Dow Jones REIT (NYSEArca: RWR) and others.

Fact and perception – decoupling is back

When the financial media talks about decoupling, it usually refers to the performance divergence between U.S. markets (NYSEArca: VTI), or developed markets (NYSEArca: EFA), and emerging markets (NYSEArca: EEM).

These days, however, the epicenter for decoupling is the discrepancy between fact and perception.

Below is a simple example taken from the car industry, another industry that got shaken by the credit crisis. Within 20 minutes, the following two headlines popped up. Associated press on January 5, 2010 at 12:24 pm: “Chrysler, Ford report double-digit drops for 2009.” At 12:43 pm by Reuters: “Ford surges as U.S. auto sales end ’09 on uptick.”

Chrysler sold 931,000 cars last year. The last time Chrysler sold less than 1 million cars was in 1962 … but stocks surged.

Even though the ISM manufacturing index checked in at 55.9 and, according to Wall Street, is signaling a recovery, it is interesting to see that only nine out of the 18 industries the index covers, were up. It seems like some seasonal adjustment factors may have put a favorable “spin” on the ISM index data.

The divergence between fact and fiction becomes more obvious when we plot economic performance against the stock market. The S&P 500 (SNP: ^GSPC), Dow Jones (DJI: ^DJI) and Nasdaq (Nasdaq: ^IXIC) all rallied more than 65% since March and recorded a 2009 performance of 20% plus. Did the economy or corporate profits validate the 20% + bounce? Judge for yourself:

Going into 2009, the forecast for S&P 500 operating earnings per share (EPS) was $77. Based on cause and effect, it would be reasonable to assume that higher stock prices translate into higher earnings. Not so, the actual EPS for 2009 clocked in at $56.

The herding effect – at the wrong place at the right time

Unfortunately, we don’t have the time to discuss the herding effect in full detail right here (a detailed explanation is available in the November issue of the ETF Profit Strategy Newsletter).

Here’s a brief synapses: Rising prices attract the attention of the media, which in turn passes on the information to the investing masses. The media coverage turns looky-loos into owners, which drives up prices. This cycle continues until there are no more, or not enough, buyers. At that point, the high base of owners becomes a liability to the price movement, as there are simply many more potential sellers than buyers. At that time, prices move down. A reversal of the process now starts.

Of course, there are various degrees of this cycle. The more optimistic investors are at the top, the more downside potential exists. The more pessimistic investors are at the bottom, the more upside potential exists.

The ETF Profit Strategy Newsletter interpreted the extreme pessimism seen in late February/early March (along with many other indicators) as a direct sign that a market bottom is close. Via the March 2nd Trend Change Alert, the newsletter recommended to close out the previously recommend short ETFs and start accumulating long and leveraged long ETFs.

Today, the astute investor observes an optimistic sentiment that hasn’t been seen in years, even decades. Investors Intelligence just reported the lowest percentage of bearish advisors since 1987 and the highest percentage of bullish advisors since December 2007. This unfounded optimism proved to be trap in 1987 and to an even larger degree in 2007.

The one emotional trick we mentioned above is to do exactly the opposite of what strongly entrenched crowd behavior would cause you to do. Doing so would have protected you from the 2000 tech (NYSEArca: XLK) bubble burst, the 2007 financial (NYSEArca: XLF) bust, and from selling stocks in February/March 2009.

Another example was seen in the U.S. dollar (NYSEArca: UUP) just a few weeks ago. On November 13th, the ETF Profit Strategy Newsletter wrote: “The U.S. Dollar Index has been bouncing around 75 for over a month now and seems to either have found or be close to a bottom.” Today, the U.S. Dollar Index sits at 78. The spike from the lows has erased over four months of gains for dollar shorts.

Similar excessive optimism was seen in gold (NYSEArca: GLD). Despite major purchases by central banks, gold dropped from its high of $1,229/oz to below $1,080/oz in less than a month.

Other bubbles in the making might be seen in the bond market. Corporate bond funds such as iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEArca: LQD), broad bond market ETFs like the iShares Barclays Aggregate Bond Fund (NYSEArca: AGG), and Vanguard Bond Fund (NYSEArca: BND) may soon see a flipside of crowd behavior – this time to the downside.

Valuations – the grim reaper

Here’s what history shows, plain and simple: 1) At times, the perceived value of stocks may disconnect from their intrinsic value, but 2) At no time does such a condition persist indefinitely. The market always brings the perceived value down to the real value. What is the real value?

A company’s value to its shareholders is measured by the ability to generate profits and pass those on to its shareholders. The higher the profits the more investors are willing to pay for the company’s shares. If there are no profits, investors are better off putting their hard earned dollars elsewhere.

This principle applies to individual companies as well as indexes, and the entire stock market. Currently the S&P 500 trades at 88 times current earnings. This means, it would take the S&P constituents an average of 88 years to repay the money investors have loaned them by buying their shares. Historically, that number is between 10 and 25. In other words, the P/E ratio for the S&P 500 sits right now at 88, an all-time high.

How about dividends? At no other time have dividends been cut faster than in 2008 and 2009. In fact, dividend yields are close to their all-time lows, which were seen in 1999 – right before the tech bubble burst.

Even though it seems clear that stocks are overvalued, Wall Street would like us to believe that this time is different. Unfortunately, it’s not.

Investors can chose to believe Wall Street and the economists – the same ones who didn’t see the 2000 or 2007 crash coming – who’ve proclaimed the recession is already over, or open their eyes and see the facts.

The November issue of the ETF Profit Strategy Newsletter includes a detailed analysis of P/E ratios, dividend yields, mutual fund cash levels, and other indicators plotted against historic and current prices. Based on those trusted parameters, a target range for the ultimate market bottom and top for this rally are given.

Soon it will be evident if this time is different.