With real interest rates having been negative for nearly four years, you would expect asset markets to be in a bubble. Debt markets, with long term bonds offering yields well below the expected level of inflation, and commodities where gold is currently trading at twice its famous 1980 peak, certainly seem to exhibit bubble valuation symptoms. Yet equity markets in general do not appear excessively valued in terms of earnings — the Standard and Poor’s 500 index is trading on only 14.9 times earnings, hardly a frightening level. When you look more closely however, you see clearly that the equities bubble rests not on valuation in terms of earnings, but on earnings themselves.

Share prices will sometime correct to a much lower level in real terms (or inflation will catch up while they remain static, as in 1966-82). But the correction will mostly take the form, not of lower price-earnings ratios, but of a massive squeeze in earnings (again, subject to inflation probably doing some of the work.) Share prices will decline only modestly in terms of price-earnings ratios, but the decline in earnings will cause a massive overall decline.

It has to be remembered: the 4,000 which the Dow Jones index hit in February 1995, the day after Alan Greenspan gave his Congressional testimony that loosened monetary policy (as it turned out, for decades to come) is equivalent to only about 8,400 on the index today, when you adjust for the last 17 years increase in nominal U.S. Gross Domestic Product. Since 1995’s 4,000 was at worst a middling Dow level, nearly 50% above the 1987 high, at today’s 13,000 the Dow is about 55% overvalued, and has been overvalued ever since 1995, except for a very brief period in February-March 2009. At the bottom of that recession, I had a modest crisis of conscience, in case the Bear outlook was about to become misguided for a prolonged period. I need not have worried; it has been appropriate for almost all the 11½ years I have been writing the column, and at least in the short term appears to be getting righter!

The poster child for the profits bubble is Apple (Nasdaq:AAPL). Apple’s valuation looks reasonable, at 15.4 times earnings, but the truth nobody seems willing to address in the middle of all this mania is that Apple cannot grow like this forever, or even maintain its current profits. The problem is not accounting shenanigans, but Apple’s 37.7% sales margin and 91.3% annualized return on equity in the quarter to December 31. Those are not just unsustainable, they are completely unsustainable. The fourth quarter saw the introduction of a successful new product, the iPhone 4S and the immense outpouring of very justified international emotion on the death of Steve Jobs.

Jobs was a unique genius, without question. But, being unique, he was also irreplaceable. Apple is perfectly well managed without him, and it has many good people, but other companies have good people too. And if Apple is no longer led by a supreme genius, then over time, Apple’s sales margins of 37.7% and return on capital of 91.3% are history.

Remember: the company does not have a unique manufacturing capability; its products are manufactured by the Taiwanese Foxconn, which also manufactures for many other brands. Apple design is excellent, superior even, but over time, as the unique fashion value of the Jobs/Apple combination fade, people will come to pay only modest premiums for superior design.

At that point, Apple top management will have two stark choices. The company can remain within the product categories in which it has already succeeded. In that case, profit margins will decline to at most half their current extraordinary levels, while sales increase only gradually, with the overall expansion of the market for those products. If Apple tries to maintain its price premium, its market share will erode.

Apple’s $97.5 billion in cash however gives its management a second option. It can seek to expand through acquisition, moving in to new product categories and expand margins in those products through applying Apple branding and design. We might see Apple flat-screen televisions, Apple digital watches, Apple home appliances, Apple handbags, Apple SUVs, Apple restaurants and maybe even Apple apples. By doing this, Apple management will spend the cash, but it will find the new acquisitions contribute little to profits, let alone margins. Sales will increase, but profitability will become sluggish, and quality control will suffer both in the new businesses and in Apple’s areas of core strength, as management is distracted by acquisition games from running the core business properly. Apple’s share price will decline sharply and the company will become a sluggish conglomerate, fit only to be carved up by ruthless Mitt Romneys.

What is demonstrably true about Apple is true about U.S. corporations as a whole. According to the Bureau of Economic Analysis, corporate profits after tax (roughly, the E on which P/E ratios are based) in 2011 totaled about 7.2% of gross domestic income (we don’t yet have final figures) up from 6.9% of GDI in 2010. That’s 50% above the overall average over the period of the BEA’s statistics, 1929-2011. It is 13% above the 1997 and 2006 cyclical peaks of 6.4%, even though the U.S. economy is currently operating far below capacity with high unemployment. It is even 2% above the previous post-World War II peak in the history of the series, 7.1% in 1965, a year in which the U.S. economy was overheating in the Vietnam escalation.

There is however one year in the BEA’s history in which the ratio was higher than it today: 1929, when it was 8.8% (at a pre-tax level, 1929 profits were also higher than today’s, but by a lesser margin, corporate tax and taxes in general being much lower then.)

The driving factor for most companies in the extraordinary level of corporate profits after tax becomes evident when you look at the same statistic’s 3.9% average over the decade of the 1980s. That was a period of high real interest rates that included a recession almost as severe as the recent unpleasantness, but when overall the unemployment rate was much lower than today. Thus in the 1980s, corporate profits were 18% below their long-term average, and barely more than half their level today. It becomes clear that the overall level of real interest rates plays a crucial role in the profit picture.

This is not surprising, especially in the post-1995 era when corporations, encouraged by very low real interest rates, have been more leveraged than at any time in history. Currently the debt/equity ratio of non-farm non-financial corporate business is around 60%, slightly above its 1990s peak and almost double its average level in 1960-85, before the new corporate finance revolution of the Modigliani-Miller Theorem took off. Since debt interest is tax-deductible, it represents very cheap capital in itself, so adding more debt should allow corporations to use more capital and thereby increase profits. Further, when debt represents 60% of equity, a decline of 4% in the real cost of debt (such as we have seen comparing its current level from the pre-1995 average) will add 2.4% to the return on equity.

At some point therefore, the end of Ben Bernanke’s misguided monetary policy (probably triggered by an unpleasant burst of inflation accompanied by insanely high oil and commodity prices) will cause corporate earnings to revert to their long-term average, losing their current 55% premium and returning stock prices even on their current fairly elevated P/E ratio to around the 1995-equivalent level of 8,100 on the Dow. Add to that a decline in the P/E ratio on the S&P 500 index to 10 times, and you get a value on the S&P 500 index of 589, equivalent to perhaps 5,500 on the Dow.

That’s without factoring in a renewed recession, which would presumably drive earnings below their equilibrium value and possibly drive stock prices below the 5,000 level on the Dow Jones index.

In terms of timing, this denouement depends entirely on the duration of Bernanke’s current monetary policy. Fourth quarter 2011 earnings for non-financial companies, with earnings season nearly over, are expected to have increased by 7.1%, considerably faster than the 4% rise in nominal GDP – pushing the key ratio of profits after tax to GDP up to roughly 7.7%, still further in nosebleed territory. Currently, estimates for first quarter 2012 earnings are coming down fairly rapidly, and have just crossed the zero line at which a decline from fourth quarter earnings is expected. Thus even with the economy continuing to expand modestly, and some few of the unemployed finding jobs, the short-term prognostications for earnings are pretty downbeat. If the bubble is not yet bursting, it may at least be close to maximum inflation.

It seems likely that we are within months of a precipitous cliff, at which interest rates rise, profits fall sharply and the stock market collapses. This will be accompanied by numerous commentators complaining that the stock market is not at bubble levels, in terms of valuation. But even in today’s recession tail-end, profits are truly bubble-level – and that is even more important.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)