Enron did it, Worldcom did it, Global Crossing did it ... and they weren't the only ones.

Today, the major U.S. indexes a la S&P 500 (SNP: ^GSPC) and Dow Jones (DJI: ^DJI) are displaying the same symptoms Enron, Worldcom, Global Crossing, and others did several years ago.

Bear markets are the best auditors, and the bear market aftermath of the tech-bubble burst revealed serious cases of 'creative accounting' with many major corporations. Such creative accounting kept stock prices rising, even though the underlying business was deteriorating.

Concerning the major U.S. indexes, there is no creative accounting going on - at least not to our knowledge - however, the prices of the Dow Jones (NYSEArca: DIA - News) and S&P 500 (NYSEArca: SPY - News) are rising, even though many of the previously leading sectors are already deteriorating.

Overall market snapshot

Some sectors always boom more than others, but a new bull market is created and kept in force when all sectors pull their weight. Currently, five of the nine S&P industry sectors have reached new highs in November while four are trading below their respective October highs.

Here are the Select Sector SPDR ETFs that have created new highs just recently:

Consumer Staples Select Sector SPDR (NYSEArca: XLP - News), new high on 11-13-09

Consumer Discretionary Select Sector SPDR (NYSEArca: XLY - News), new high on 11-13-09

Industrial Select Sector SPRD (NYSEArca: XLI - News), new high on 11-13-09

Technology Select Sector SPDR (NYSEArca: XLK - News), new high on 11-13-09

Healthcare Select Sector SPDR (NYSEArca: XLV - News), new high on 11-13-09

Here are the Select Sector SPDR ETFs that trade below their previous highs:

Materials Select Sector SPDR (NYSEArca: XLB - News), old high on 10-19-09

Utilities Select Sector SPDR (NYSEArca: XLU - News), old high on 10-19-09

Energy Select Sector SPDR (NYSEArca: XLE - News), old high on 10-19-09

Financial Select Sector SPDR (NYSEArca: XLF - News), old high on 10-14-09.

A deeper look

The fact that not all industry sectors have reached new highs, in itself is not necessarily alarming. A deeper look under the market's hood, however, reveals some tendencies with serious 'red flag potential.'

You may have noticed that financials peaked earlier than any other of the nine S&P industry sectors (10-14-09). If we expand our deep tissue market analysis to other sectors of importance, we find that the regional banking sector (peaked in August) and real estate sector (peaked in September) have been declining for weeks and already trade 10%, or more, below their prior highs. Once again, this is despite the Dow Jones and S&P 500 reaching new highs just a few days ago.

What goes around comes around

Over the past several weeks, investors have gotten inundated with all kinds of economic data and it's easy to get confused. To prevent analysis paralysis, it helps to simply get back to the basics. What got us into trouble? Has that problem been fixed?

Falling real estate prices and insufficiently secured mortgages were the epicenter of the post 2007 meltdown. In order for the economy to move on and get better, this issue would have to be resolved, just as a patient shouldn't walk out of the hospital until taking a turn for the better. So, have the major issues been solved?

Just a few days ago, the Associated Press (AP) reported that median sales prices of existing homes declined in 123 out of 153 metropolitan areas, compared with the same period a year ago. The national median home price clocked in at $177,000, or 11% below the third quarter last year.

Let's take a quick glance at the balance sheet of the Federal Housing Administration (FHA).  The FHA is the federal agency in the Department of Housing and Urban Development that insures residential mortgages and has insured nearly a quarter of all new loans made this year, about 80% of which are from first time buyers.

Different time, same problem

AP reports that FHA's losses have already increased as more homeowners default due to losing their job. About 17% of FHA borrowers are at least one payment behind or in foreclosure. This compares with 13% for all loans, according to the Mortgage Bankers Association.

An independent audit shows that FHA's reserves have fallen to $3.6 billion. A small amount compared to the $685 billion worth of outstanding loans the FHA insures. FHA's capital ratio is at 0.53%, far below the 2% threshold required by congress.  Even those of us who don't have memories like an elephant can remember that kind of leverage causing a lot of trouble just recently.

Despite the problems still haunting the real estate market, the ETF Profit Strategy Newsletter predicted in its February 2009 issue that; 'Similar to U.S. stocks, real estate prices should recover temporarily.' What was forecast for the U.S. stock market?

After predicting a market bottom below Dow 6,700 (the Dow bottomed at 6,547), the ETF Profit Strategy Newsletter expected the biggest rally since the October 2007 all-time highs and recommended to start buying long and leveraged long funds via the March 2nd Trend Change Alert.

Unlike any other industry, the fortune of banks (NYSEArca: KBE - News) is directly linked to the fortune of real estate and the stock market. Why? Because banks are the single biggest owners of toxic assets. Banks' balance sheets can't recover for good unless property prices rise. Rising stock prices, however, will provide a temporary bandage as 1) the bank's own stock portfolio lifts their entire balance sheet and capital ratios and 2) the perception that things are improving keeps many mortgages still performing to some extent.

Therefore, banks' performance ties together what's really going on with real estate and stocks. Aside from the fact that the banking and regional banking sector have been declining for weeks (see chart above), there are other outright alarming factors.

Banks: from lender to hoarder

Banks' collective cash reserves have reached an all-time high of more than $1.2 trillion. This is an increase of about 400% compared to 2006 when banks' cash reserves were about $300 billion.

Conversely, banks' collective lending activity has dropped to the lowest level in many decades. Even though consumers desperately need loans, banks are content to forego the opportunity to lend. Banks have turned from lending institutions into hoarding institutions.

It doesn't take a rocket scientist to figure out something's not quite right, if banks decline the chance to use money to make money. Something has to be in the air, if once aggressive money sharks turn into tame monkey seals.

Of course, the market can rally big and all major U.S. sectors could once again be on the same page. However, seeing that financials and banks are more than 10% below their prior highs, it would take a big, concerted push across the board.

Examining the market with a short-term lens, such a push seems unlikely primarily because there has been no conviction behind the most recent 10-day rally leg. Volume has been declining since early November and reached anemic levels.

Big picture stuff

There is no reason though to get caught up with micro-managing the short-term potential of the market. The market's long-term journey presents a huge opportunity for savvy investors.

Once again, it helps to block out all the background noise and zero in on what counts. Despite high-tech computer driven analysis, the signals given directly by the market are still the most reliable way to gauge the market's direction and target range.

Historical patterns show that stock will only deviate from their true value for a limited time. Eventually, stock prices always return to their fair value. Fair values are just as consistent - in fact they are much more consistent - than bubbles and their subsequent busts.

The easiest and most effective ways to measure values are via dividends and P/E ratios. High P/E ratios spell trouble and low dividend yields spell trouble. High P/E ratios and low dividend yields are a recipe for disaster.

 

Based on the most recent earnings report, the P/E ratio for the S&P 500 (as reported by Standard and Poor's) is 85.55, down from 138 a few weeks ago. Those are the highest readings ever seen on Wall Street. Additionally, dividend yields are close to their 1999 all-time lows (we know what happened right after 1999).

Based on those simple measures, stocks are still grossly overvalued. In other words, the patient is sick. Just as the human body is not healthy unless the body temperature clocks in around 98.6 degrees, the stock market is not healthy unless dividend yields and P/E ratios reset to fair valuations. Fair valuations have always coincided with very low P/E ratios and very high dividend yields, just the opposite of the current picture.

The November issue of the ETF Profit Strategy Newsletter plots the historic performance of the stock market against P/E ratios, dividend yields, and other common sense long-term indicators. These indicators have a track record of accuracy and point toward target levels for the ultimate market bottom. A picture paints a thousand words and those charts speak volumes about the market's future.