A balloon that has been punctured does not deflate in an orderly way. Asset bubbles, once ruptured, do not deflate in an orderly way either.

Bubbles always have one thing in common. They arise and pop unexpectedly. The very fact that you might be thinking there are no major bubbles right now, is actually one of the key ingredients needed for bubbles to form, grow and ultimately bust.

Bubble trouble?

Bubbles occur in a very particular, pre-defined pattern. First, there are rising prices, whether stocks, real estate, commodities (NYSEArca: DBC) or even bonds.

Rising prices attracts attention and buyers, which in turn results in even higher prices. For a while, this becomes a self-fulfilling prophecy as expectations are justified by the very action that sends prices higher.

This process continues until the sentiment that higher prices are here to stay sets in. Notions of a bubble at that point are dismissed. “This time is different” is the most commonly used expression of dismissal.

In 2008, it was “different” with oil (NYSEArca: USO). The world was running out of oil. Just as analysts began to prepare us for $200/barrel oil, oil prices started to tumble, more than 75% top to bottom.

The first few months of the past decade were christened by the bust of the tech bubble (NYSEArca: XLK). Hardly anyone foresaw the Nasdaq (Nasdaq: ^IXIC) dropping from above 5,000 to below 1,500, yet it did.

Fortunately, the early 2000s recession was softened by rising property prices. This ultimately resulted in the real estate bubble, which no one foresaw.

In fact, in 2004, Alan Greenspan said the rise in home values was “not enough in our judgment to raise major concerns.” In 2005, Ben Bernanke said that a housing bubble was a “pretty unlikely possibility.” Even in 2007, Bernanke stated that the Fed “does not expect significant spillovers from the subprime market to the rest of the economy.”

Well, spill over it did. In fact, the tentacles of the real estate bust were as far reaching as they were unexpected. By the end of 2007 they had infected the financial sector and broad market indexes a la S&P 500 (SNP: ^GSPC) and Dow Jones (DJI: ^DJI).

By 2009, the ramifications of toxic real estate assets had nearly eliminated key financial players and severely damaged the foundation of our entire financial system; Once again, unexpectedly. 

It’s easy to conclude that there are no current bubbles. History, however, teaches us that bubbles never have been, and likely never will be expected. Therefore, it makes sense to fine-tune and double check our bubble-radar.
 
Real estate – the bubble continues

Talking about real estate is serious business. The real estate sector more or less single-handedly took down the stock market and the entire U.S. economy. For right now, real estate is the key U.S. sector to watch – as real estate goes, so goes the market.

It’s generally believed that the real estate bubble started to deflate in 2005/2006 and is close to a bottom right now. A look at P/E ratios shows that investors have little concerns about another wave of real estate related problems. According to AltaVista Research, the Vanguard REIT ETF (NYSEArca: VNQ) trades at a P/E of 73.8%, while the iShares Cohen & Steers Realty Majors (NYSEArca: ICF) trades at 82.9.

Naturally, the banking sector, which is closely linked to the real estate sector via easy lending induced toxic assets, is overvalued as well. AltaVista reports a P/E ratio of 64 for the KB Bank ETF (NYSEArca: KBE).

In December, Bloomberg reported that U.S. banks are choking on real estate loans. Unpaid loans on malls, hotels, apartments, and home developments are at a 16-year high. U.S. apartment vacancy rates hit a new all-time high of 8.0%. Landlords were forced to cut rents by 2.3%, the most pronounced cut since records began in 1980.

Largely due to under-performing real estate loans, regulators have shut more than 130 banks last year. The banks are in such bad shape that the FDIC has a hard time finding buyers.

Mythbuster! Safety in bonds

Bonds are generally perceived to be much safer than stocks. Strategic Insight, a business intelligence provider to the fund industry, estimates that full-year 2009 inflows to bond funds will come in at an all-time record of almost $400 billion. Clearly, the general public perceives bonds to be safe.

Investment grade bonds, such as the ones held by the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEArca: LQD), are the safest; the cream of the crop. A quick glance at a two-year chart shows that LQD dropped nearly 20% in less than two weeks in September 2008.

With a yield north of 5%, LQD and similar funds seem like a money-making cash machine. Let’s take a look at the top holdings of LQD: Wells Fargo, Citigroup, Merrill Lynch, JP Morgan, etc. The list of top holdings is uncomfortably similar to the top holdings of the Financial Select Sector SPDRs (NYSEArca: XLF), a fund that lost about 80% in the post 2007 meltdown.

Yes, LQD is a bond version of XLF, but that doesn’t mean there’s no risk. The Wall Street Journal just reported that lender CIT Group was able to eliminate $10.5 billion worth of debt by filing for chapter 11 bankruptcy. In 2009, Chrysler and GM filed for bankruptcy. Bond holders received less than 30 cents on the dollar.

Broad bond ETFs like the iShares Barclays Aggregate Bond (NYSEArca: AGG) and Vanguard Bond ETF (NYSEArca: BND) are heavily invested in Fannie Mae and Freddie Mac. In fact, the top seven holdings of AGG are Fannie or Freddie bonds.

In late December 2009, the Treasury Department recognized that losses for Fannie and Freddie will be more than $400 billion. The Treasury also stated that it will provide unlimited assistance. Bond holders essentially lend money to a broken business which is supported solely by government subsidy. Is that a prudent investment?

If a deeper look at “investment grade bonds” has you concerned, you may not want to look at high yield or junk bonds. Funds like the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca: HYG) have performed very similar to stocks. In fact, junk bonds have matched the performance of stocks; a never before seen event.

A turn of events

This turn of events, from risk aversion in 2008 and early 2009 to risk addiction was unexpected for many. In early March, the ETF Profit Strategy Newsletter expected a major low and recommended to start buying long and leveraged long ETFs via the March 2nd Trend Change Alert.

As per the Trend Change Alert, the top of this rally was to be marked by extreme investor optimism and the sentiment that the March lows are here to stay. This sentiment is not just visible; it has also had time to become well established. Investor’s appetite for junk bonds and bonds that hold junk is yet another manifestation of the foretold optimism.

Stuff rolls downhill

It doesn’t take a rocket scientist to figure out what will happen if real estate doesn’t recover soon. We’ve seen the consequences in 2008. Without a rise in real estate prices, the toxic assets will remain toxic assets. Even though ingenious accounting practices – and rising stock prices - have hidden much of the damage thus far, the problem will likely come back to haunt Wall Street sooner or later.

Chances are this will be sooner rather than later. The rally from the March 2009 lows has pushed stocks into grossly overvalued territory. Overvalued, how so you may wonder. The P/E ratio for the S&P is only around 16, which is in line with historic averages, right?

A P/E of 16 is based on estimated 2010 operating earnings. Operating earnings do not include expenses related to marketing, layoffs, financing and M&A. Those are significant expenses not considered. Furthermore, projected 2010 earnings are north of $75.

Keep in mind that at the end of 2008, analysts expected earnings for 2009 to clock in at $77. In reality, actual reported 2009 earnings will clock in around $55 – a 27% downside revision.

Anyone interested in the real value of the S&P (and stocks in general) will want to take a look at the P/E ratio based on actual reported earnings. Using Standard and Poor’s most recent top down numbers, the P/E ratio is 88.92 (28.15 if using bottom up). No matter how you slice it, companies are overvalued.

The P/E ratio analysis is important because every major market bottom over the past 100 years saw P/E ratios drop to significant lows. We did not see such lows in March and we are certainly not seeing them right now.

The implications are clear. According to historic patterns, new lows are ahead as there was no true market bottom in 2009 just as there was no true bottom in 2002.

Of course, this is a truly contrarian view nowadays. While many will dismiss the notion of a bubble or a required re-valuation process, astute investors will take the contrarian nature of this bubble talk as a confirmation that trouble is ahead – after all, no bubble has ever been expected.

The November 2009 ETF Profit Strategy Newsletter includes a detailed analysis of P/E ratios and four other valuation plotted against historic stock prices in order to pinpoint the target range for the ultimate market bottom.