Dogs are conditioned to perform tricks in order to receive a treat. Horses are conditioned to trot or gallop at command. Humans are conditioned to deny the existence of a bear market.

Conditioning is defined as a process of behavior modification by which a subject comes to associate a desired behavior with a previously unrelated stimulus. It’s ironic that Webster’s uses the term ‘stimulus’ to define conditioning, because that’s the same term the government has used.

In fact, the government’s and stock market’s actions have conditioned investors to believe that the worst is behind them. Anytime we are presented with data that points towards a recession or depression, the general consent is: “This time is different!”

Unemployment is up, housing is down but stocks are up, so things must be different. That’s at least the logical conclusion on Wall Street.

This Time is Different

Some called the 2008 meltdown the perfect storm. All asset classes declined at once, something that hadn’t been seen since the Great Depression. Perhaps this is the first clue that this time really is different.

We’ll discuss a couple of other reasons and work ourselves up to “the big one.”

In 2008 all asset classes saw the wrath of the bear. Large caps (NYSEArca: IWB), mid caps (NYSEArca: MDY) small caps (NYSEArca: IWM) and real estate (NYSEArca: IRY). Commodities (NYSEArca: DBC), oil (NYSEArca: USO), silver (NYSEArca: SLV) and even gold (NYSEArca: GLD) followed.

Why is the post-2007 recession worse than the 2000 tech (NYSEArca: XLK) collapse, or the 2005 real estate (NYSEArca: RWR) bust?

Very simple, when the Nasdaq (Nasdaq: ^IXIC) tumbled in 2000, real estate was there to comfort investors financially. When real estate collapsed in 2005, stocks were there to cheer up pouty real estate investors. In 2008, there were no comforters or safety to be found anywhere.

All for One – One for All

If you spin this thought further, you notice that the performance of asset classes is still interconnected. The rally from the March lows lifted all asset classes and aside from gold, most asset classes topped when stocks did in April 2010, and ultimately turned south. If you are trying to compile a diversified portfolio, you know exactly what I’m talking about. We’ll discuss in a moment why this is a problem.

Real Estate – The Weakest Link

June housing starts fell to the lowest level since October. New home sales cratered an unprecedented 33% in May. Only 300,000 new homes were sold. The prior low was at 341,000 in April 2009, at the depth of the recession.

The expiring tax credit must have caused a ton of cancellations too, as sales for April were readjusted from 504,000 to 446,000 units and March from 439,000 to 389,000. It is no surprise that the median home price dropped 9.6% month-over-month.

About 25%, or one in four borrowers, found that they owe more than their home is worth. The Treasury Department reported Wednesday that newly initiated foreclosures increased 19%. The number of short sales increased 9.2% for the quarter and 120.4% for the year.

According to the same report, more than half of all homeowners with modified mortgages fell at least two months behind in their payments. The pipeline for yet more foreclosures and short sales remains stuffed.

The Negative Real Estate Feedback Loop

Thus far, we are led to believe that everything in the U.S. is fundamentally sound, even though Europe is struggling. Much of that belief is nurtured by positive earnings reports. Earnings from the banks (NYSEArca: KBE) and financial sectors  (NYSEArca : XLF) soared about 300% year-over-year.

But what if those earnings were incorrect and omitted important information, or were simply designed to deceive investors. A recent accounting change allows for exactly that.

CFO.com reports that the change to rule 157 allows banks with impaired financial securities to move billions of dollars in losses off of their income statements, which will benefit their regulatory capital calculations and artificially increase profits. The rule revision approved on April 2, 2000, addresses how companies account for assets whose market value has fallen below the reported balance-sheet value.

Financially Engineered Profits

How does the new rule 157 work? In an oversimplified example, bank A holds a securitized pool of mortgage-backed assets originally valued at $100. After modeling the future cash flow of the pool, the bank determines it will ultimately collect $95. The credit loss is $5. However, due to economic factors, the MBA pool is currently worth only $40, a $60 loss. The difference between the two calculations ($60 - $5) is the noncredit loss - $55.

The new rule 157 allows banks to dump the noncredit loss into an account, which is not recognized on the banks’ income statements. As such, credit losses do not show up in the earnings numbers. Therefore, earnings are grossly overstated.

Falling real estate prices intensify the already bad situation as the gap between what banks’ think they’ll be able to sell their assets for eventually in a healthy market and what they are worth currently, continues to widen.

You and I know that the real estate market may never return to the pre-recession levels. Banks know it too, that’s why they wanted the 157 rule change to buy more time. They’ve used that time to make more faulty loans and pray they will somehow be repaid. In Vegas this is considered a double-down or all or nothing bet.

Postponed is not Deleted

In late 2008 and early 2009, the media picked “too big too fail” apart like a vulture tears into a carcass.  The disturbing news revealed sent markets spiraling and created a negative feedback loop. Bear markets are the best auditors.

In fact, the market’s internal signals revealed months ago that the disconnection between rising stock prices, ailing financials, and the deteriorating economy was about to culminate in a concerted decline.

On April 16, with the S&P (SNP: ^GSPC) above 1,200 and the Dow (DJI: ^DJI) above 11,100, the ETF Profit Strategy noted that “most bulls have no clue why they are bullish except for the fact that they feel the need to play the momentum game. The upside potential is much more limited compared to the massive downside risk. The pieces are in place for a major decline.” A break below S&P 1,040 was given as the first downside target.

The mentioned upside potential was exhausted on April 26, the day the major indexes peaked, before falling as much as 15%. Since then, the S&P has fallen below its 200-day moving average and failed in several attempts to climb and/or stay above it. Volume on up days has been much weaker than on down days (click here for a detailed volume analysis).

Unlike Wall Street, the market does not lie. What you see is what you get. Rarely in history has there been such harmony between technical indicators, valuations, fundament measures and sentiment readings. The conveyed message is clearly bearish.

Each issue of the ETF Profit Strategy Newsletter features a detailed analysis of various indicators along with short, mid and long-term forecasts. The July issue includes the one chart that explains the immediate downside risk and the target range for the ultimate market bottom.