Guilty pleasures, who doesn’t have one? For some it might be chocolates, for others cars, TV shows, or something else you should feel really guilty about.

Famed value investor Jeremy Grantham said that “riding a bubble is a guilty pleasure totally denied to value managers.”

Being denied some of the bubble benefits in exchange for avoiding some of the bubble-burst headaches isn’t such a bad idea. It’s a type of insurance premium. As with any insurance, it hurts to pay until you need it and then you are glad you have it.

Very few investors have the talent to consistently jump off the wagon before it crashes. In fact, history shows that most jump on the bandwagon as it’s heading for the cliff.

The ones that get out in time know that there are warning signs. Those warning signs are unmistakable, although not infallible when it comes to timing.

A market that registers one or two extremes gives reason for concern. A market that registers multiple extremes, particularly long-term extremes, raises a fluorescent red flag.

A decade of extremes

The years 1999/2000 were a time of extremes. In the last nine months of its rally phase, the Nasdaq (Nasdaq: QQQQ) exploded and doubled before crumbling. This rally was based on expected earnings of brand new internet and tech (NYSEArca: XLK) companies with no track record. As sharp as the rally was, the decline was even more powerful.

The years 2007/2008 were another period of extremes. Financial companies (NYSEArca: XLF), never known for their hard work, found a way to make money even easier – trading and selling financial derivatives.

In retrospect, it is quite amazing that this financially engineered house of cards did not collapse earlier. But with the real estate sector (NYSEArca: IYR) weakening significantly, it was just a matter of time before the sub-prime avalanche would hit the fan and Wall Street.

Looking back it becomes obvious that the last ten years are composed of a cycle of building and deflating bubbles. The euphoria of rising markets was quickly distinguished by the pain of bursting bubbles. One thing we should have learned by now is that euphoria is the perfect breeding ground for problems.

Fool me once, …

As humans we are equipped with longer-term memories than rabbits and are generally reluctant to get burned twice. This decade has seen many get burned three times. Once with technology, once with real estate and once more with stocks in general (NYSEArca: TMW).

There seems to have been just enough time between 2000 and 2007 to forget the tech-bubble and real estate, well real estate is a different asset class and was supposed to go up at all times – but it didn’t.

Turn on the GPS

It is easy to forget where we are today. Let’s turn on the GPS to get a read on our exact location. Over the past year, the Dow Jones (DJI: ^DJI), S&P 500 (SNP: ^GSPC), Nasdaq (Nasdaq: ^IXIC), small caps (NYSEArca: IWM), mid-caps (NYSEArca: MDY), large caps (NYSEArca: IVV) and virtually all other asset classes have gained 70% or more.

This in itself is an extreme that has never happened before. For nearly six weeks, investors haven’t seen a broad index lose more than 1%. There hasn’t been more than four hours of selling pressure since the February 8 lows.

Those extremes are amazing by themselves. But wait, there is more.

Last week the National Association of Active Investment Managers (NAAIM) reported that 95% of active mutual fund managers are net long. This is the highest reading since October 17, 2007.

Investors are feeling the same way. In December, portfolio cash allocation dropped to the lowest level since April 2000, while stock allocation rose to the highest level since September 2007 (according to AAII).

Last week, the Volatility Index – VIX (Chicago Options: ^VIX) dropped to its lowest level since July 2007.

On December 31, 2009, the percentage of bearish investment advisors dropped to the lowest level since April 1987, while the percentage of bullish advisors spiked to the highest level since December 2007 (according to II). The chart below illustrates just some of the recent extremes (timeframe December 1, 2009 - March 22, 2010).

                                                                                                        
On borrowed time

No doubt, extremes can go on for a while. Nevertheless, it is interesting to note the common denominator between all extremes – the year they last occurred are 1987, 2000, and 2007. All those years had one thing in common – major declines.

Is this time different?

To a larger degree than in the past and at all cost, the government is doing all it can to prop up the economy (see related article “What or Who is Driving Up Prices”). And even though this might be working right now, we know that the government’s actions usually accomplish the opposite of what they intend.

Take the Glass-Steagall Act as an example. It was a law designed to control speculation. This law was established in 1933, the year the Great Depression ended and was repealed in 1999, just before the tech bubble burst.

The current rally is as unprecedented as it has been unexpected. A little more than a year ago, Wall Street was bracing itself for a repeat of the Great Depression.

It was at exactly that time, on March 2, 2009, that the ETF Profit Strategy Newsletter sent out a Trend Change Alert, recommending to sell short ETFs and buy long and leveraged long ETFs like the Ultra S&P 500 ProShares (NYSEArca: SSO) and Ultra Financial ProShares (NYSEArca: UYG). The target for the end of this rally was Dow 9,000 – 10,000, which should be marked by extreme levels of optimism and a “the worst is over attitude.”

The market has certainly delivered on this outlook. You may find it interesting that the percentage of stock market bulls reached a record-low at that time. Once again, when it was time to buy, investors at large turned to cash.

Valuation extremes

When it comes right down to it, valuations are the only thing that really matters. After all, who wants to overpay?

Perception often drives valuations for a period of time. You may remember when VW re-launched the Beetle or BMW unveiled the brand-new Mini Cooper. Initially dealers were able to charge up to $5,000 on top of the MSRP simply because buyers would pay it.

Today you can pick them up on the cheap simply because consumers won’t pay a premium. What’s changed? Perception. The same holds true for the Toyota Prius, which was a hot commodity during the $5/gallon gas price era and is plagued by recall troubles today.

Just like cars or hot Christmas toys, stocks are largely driven by perception and valuation. History, however, shows unequivocally that profit margins, P/E ratios, and dividend yields always trump the perception of prices and pass through fair value eventually.

Two extremes we haven’t mentioned yet are P/E ratios and divided yields. Market bottoms are signaled by low P/E ratios and high dividend yields.

Just a few months ago, Standard & Poor’s pegged the P/E ratio based on reported earnings at 143, more than 10 times its historic average. Dividend yields have fallen close to the 1999 all-time low. This is not what a new bull market is made of.

Even though momentum still keeps prices going up, now is the time to prepare for when they won’t be. Every investor needs to know where fair valuations are to determine the downside risk.

The ETF Profit Strategy Newsletter includes a detailed analysis of valuations set against historic market bottoms along with a short, mid and long term forecast. The long-term forecast includes a price range for the ultimate market bottom.