http://www.etfguide.com/research/213/8/Is-The-Worst-Really-Over?/ Is The Worst Really Over? By, Simon Maierhofer Aug 17, 2009 Are you a glass half full or half empty kind of a person? More importantly, are you able to discern an empty glass? Wall Street views the stock market through âhalf-full gogglesâ, even though economic news continues to disappoint. Currently, 150 banks are at the brink of bankruptcy, the S&Pâs P/E ratio is at 143, yet investors are enthusiastic. Is the worst really over? According to recent surveys, the majority of investors looking for light at the end of the tunnel are seeing a very bright glow. Is it really light pointing the way out, or the beacon of another collision bound train? Wall Street in general certainly believes to have seen the light. Goldman Sachs chief strategies Abby Joseph Cohen is convinced that a new bull market has begun. Nobel Prize-winning economist Paul Krugman says that the world has avoided a second recession. On July 23rd, the Wall Street Journal reported that âThe economy has hit bottom.â Furthermore, 90% of economists, according to a survey by Blue Chip Economic Indicators, believe that the recession had ended last quarter (more about the significance of this in a moment). After-the-fact prophets The astute investor will wonder where Mrs. Cohen, Mr. Krugman, 90% of the economists, and all the other Wall Street gurus were in March when the alleged new bull market actually began. Shouldnât it be possible to identify a bull market a bit earlier than a 50% rally and five months after the fact? The sobering reality is that around the March lows, Wall Street and all its followers were indulging themselves in self pity and doomsday behavior. On March 5th, the American Association of Individual Investors survey reported the most pessimistic sentiment reading in over 20 years. 70.27% of all investors were bearish, with only 18.92% being bullish. Around the same time, on March 2nd, the ETF Profit Strategy Newsletter issued a Trend Change Alert. The alert prepared investors for âthe most powerful rally since the October 2007 all-time highsâ with gains expected to exceed 30-40%. ETFs recommended at the time ranged from plain vanilla broad market index ETFs like the S&P 500 SPDRs (NYSEArca: SPY) and Dow Jones (NYSEArca: DIA), to sector ETFs such as the Financial Select Sector SPDRs (NYSEArca: XLF) and their leveraged cousins, Ultra Financial ProShares (NYSEArca: UYG). Prior to the Trend Change Alert, in early January, the newsletter recommended loading up on short ETFs, such as the UltraShort S&P 500 ProShares (NYSEArca: SDS), UltraShort Financial ProShares (NYSEArca: SKF) and others, with a target of Dow 6,700. Is this rally out of sync with reality? While after-the-fact prophets have jumped on the rally bandwagon, the economy continues to lag. Retail sales numbers have dropped yet again, top line corporate revenue continues to fall which results in more jobs being eliminated. Home prices continue to fall and foreclosures are still on the rise. In fact, they are expected to triple by 2011. Bloomberg just reported that more than 150 publicly traded U. S. lenders own nonperforming loans that equal 5% or more of their holdings. This is a level that regulators say can wipe out a bankâs equity and threaten their survival. Furthermore, a separate Bloomberg article reveals that the loans of Regions Financial, as of June 30, were worth $22.8 billion less than what its balance sheet says. With Regionâs shareholder equity at only $18.7 billion, the bankâs equity is less than zero. Yet, the bank is still classified as âwell capitalizedâ by the government. Bank of Americaâs loans were worth $64.4 billion less than their balance sheet, and Wells Fargoâs loans were worth $34.3 billion less than stated in their balance sheet. According to recent stats, U. S. banks on average operate on a 45:1 leverage. 30 times leverage means that if a bank loses 3.3%, its equity will be wiped out. At 45 times leverage, a 2.2% loss would be enough to wipe out the entire bank. Combine this with the above Bloomberg reports (5% of nonperforming loans) and you have a recipe for disaster. Incidentally, regulators just shut down Colonial BancGroup (along with 76 other banks earlier in 2009), a big lender in real estate development. With about $25 billion in assets, it was the biggest bank to fail thus far in 2009. Excluding the 19 biggest banks that underwent the stress test, banks with nonperformers above 5% had combined deposits of $193 billion, according to Bloomberg data. That is almost 18 times the size of the FDICâs deposit insurance fund at the end of the second quarter. The ETFs that will be affected first by this development are the SPDR KBW Bank (NYSEArca: KBE), iShares Dow Jones US Financial Sector ETF (NYSEArca: IYF), and eventually the broad market indexes ala S&P 500 (SNP: ^GSPC), Dow Jones (DJI: ^DJI), Nasdaq (Nasdaq: ^IXIC), Russell 2000 (NYSEArca: IWB), etc. Scary valuation metrics In general, P/E ratios are based on forward-looking or projected earnings, which often reflects wishful thinking. The P/E ratio, based on recently reported earnings, available on Standard and Poorâs website, is a whopping 143.95. This is not a typo! The earnings for S&P 500 constituent companies have declined over 95%, since peaking in Q3 2007. If current estimates hold, Q3 2009 will see the first ever 12-month period during which S&P 500 earnings are negative. P/E ratios are one of the simplest yet most accurate valuation metrics around. A historic analysis of major market bottoms show that there has not been a single prior bear market that bottomed without P/E ratios (and dividend yields) reaching rock bottom levels. In fact, those levels can even be used to calculate a target range for the ultimate market bottom. Just as the human body is not healthy unless it runs at 98.6 degrees, the stock market is not healthy unless P/E ratios and dividend yields reach those trigger levels. Needless to say, a P/E ratio of 143.95 (even P/E of 15) is far removed from levels indicative of a bottom. The Great Depression all over? The economy and stock market are forming more and more parallels with the Great Depression. In fact, no other bear market, aside from the Great Depression, compares with the bull market of the late 2000s. Even the current 50% rally parallels the bear market rally from 1929/1930. This rally was followed by another 70%+ drop. In 1929, a few months before the meltdown started, the Harvard Economic Society turned from bearish to bullish. In 1930, right at the top of the first major counter trend rally which lifted the Dow by nearly 50%, the Society confirmed its bullish outlook. A few days later, the Great Depression reasserted itself. Todayâs optimistic economists will soon learn the same lesson as their Great Depression predecessors; donât get caught up by unfounded hype. Based on investors extreme optimism, the banksâ troubles, the economyâs problems, reliable fundamental indicators, parallels with the Great Depression, and many other facts and indicators, the light at the end of the tunnel will turn out to be a train, ready to steamroll your portfolio. NaÃ¯ve investors during the Great Depression kept buying into decoy rallies, only to see more and more of their wealth evaporate. While the stock market will sink to new lows, perhaps even dwarf the Great Depression, a continued losing streak doesnât have to be the fate of your portfolio. The September issue of the ETF Profit Strategy Newsletter contains a detailed analysis of the parallels between the Great Depression and today, P/E ratios and dividend yields, along with corresponding ETF profit strategies. Also included are practical tips to survive and thrive in the coming years and target ranges for a market top and the ultimate market bottom. Yes, there is light at the end of the tunnel! Insightful investors realize that the light is attached to the âShort Lineâ railway. Will your portfolio be on board to profit in a down market?