“The pitcher goes to the water until it breaks.” The French proverb simply conveys the idea that the law of averages eventually catches up. English equivalents would be, “if you play with fire, you’ll get burned” or “don’t push your luck.”

After a 40% rally in stocks, investors should be asking themselves if the search for profits will result in a broken portfolio, or in other words, are you pushing your luck by chasing high stock prices?

This article will explain what ignited the recent rally, why the rally continues, and why it will endure only a little while longer.

Many who either lost money in the 2008 carnage, or who didn’t get to benefit fully from this rally, are wondering whether the recent news reports (better than expected earnings, revised analyst forecasts, friendly economic outlook, etc.) validate higher prices. Is it time to buy into the rally, or should you get out before it’s too late?

In case you haven’t noticed, there is a discrepancy between the news reports and reality.

Tug of war between reality and good news

One of last week’s headlines depicts the tug of war between positive earnings results and reality: “JP Morgan Profits From Investment Bank; Defaults Rise” (Bloomberg.com). This is a ‘good news – bad news’ kind of a scenario.

JP Morgan’s retail bank reported that last quarter’s prime mortgage defaults were $481 million, or 3.07%, compared to just $104 million, or 1.08% a year earlier. In short, prime mortgage defaults nearly tripled (bad news) and if it wasn’t for JP Morgan’s investment-banking revenue (good news), last quarter’s profit would have been negligible.

The earnings of Goldman Sachs, Bank of America, and other big banks paint the same picture. Are record profits from the investment-banking segment sustainable?

To answer this question, one must understand what investment-banking income consists of. Such revenue includes profits from trading financial instruments in addition to stock and bond underwriting.

According to TrimTabs Investment Research, firms have recently issued more shares of their stocks than at any other time in history. We will explain in a moment why companies would issue more shares at depressed prices, but for right now it is important to realize that part of the investment-banking income (from stock underwriting) was due to record numbers. This trend is unlikely to continue.

Furthermore, profits from trading financial instruments – another segment of investment-banking income – received a boost from the biggest rally since the Great Depression ended. Again, this trend is unlikely to continue.

How earnings fool investors

Yes, there have been a number of earnings surprises. But as any good surprise, it happened because somebody was blind-sided. The lack of understanding the underlying facts will blind-side investors several more times in the coming months/years.

Intel is another large cap behemoth that beat earnings forecast by a large margin. Unfortunately, Wall Street omits that Intel’s earnings forecast was 80% lower than their actual Q3 2007 earnings. If you set the bar low enough, companies are bound to surprise.

Caterpillar (NYSE: CAT) boosted its 2009 profit forecast, citing evidence that government stimulus plans, particularly in China are beginning to work. CAT is not the only US-based conglamorate to benefit from Chinese orders.

But this is not real growth, the positive outlook is based on Chinese stimulus money. As such, there is a catch 22; unless there will be more stimulus, this spike in revenue should prove short-lived. If on the other hand there will be more stimulus, it would be a certain indication that the economy continues to lag. Neither scenario is advantageous.

A barometer of social mood

Since the stock market is not always a reflection of true worth it is quite possible that the reality remains hidden behind a web of fluff and optimism. Stocks are worth what the composite of investors feel they are worth. As such, the broad indexes reflect the mood of investors, not always fair value.

A glance at prior depressions and recessions - such as the Great Depression which started in 1929 or Japan’s depression which started in 1990 - shows that the stock market wiggles its way from the peak to lower and lower lows. Rallies appear in regular intervals. Just as regular, is the disappointment experienced when the rally rolls over after having suckered more investors into this losing vortex.

The ETF Profit Strategy Newsletter predicted this phenomenon well in advance and at a time when no one expected rising prices. After calling for a bottom below Dow 6,700 early in 2009, a March 2nd Trend Change Alert prepared subscribers for the biggest rally since the October 2007 all-time highs. This rally was expected to last several months and buoy the stock market by 40%.

Just three days later, on March 5th, Nouriel Roubini, one of the few credible economists remaining, estimated losses on U.S. loans and securities to reach $3.6 trillion. According to his research, this implies that the financial system is currently (as of March 5th) near insolvency in the aggregate (reported by the Wall Street Journal).

Despite Roubini’s outlook, the Dow bottomed a few days later below 6,700 and went on to soar for the next few months. Financials and Banks more than doubled. What happened to the insolvent financial system? Did the problems dissolve themselves?

Of course they didn’t dissolve, but they were put on hold for a few months. Wall Street waved the white flag and investors accepted the offer. The March 3rd Trend Change Alert explained why the rally has to happen and what will mark its top:

“This counter trend rally will have to be broad and powerful in order to relieve investor's pent-up urge to buy. ” By early March, the S&P 500 and Nasdaq had lost over 50%. A broad counter trend rally was to be expected.

What will mark the end of rising prices? The Alert continues: “The down trend will resume once the rally exhausts itself. This point of exhaustion is likely to happen at a point where optimism takes over and investors think that the Q1 2009 lows are here to stay.”

Is the painted picture reminiscent of what we see today? Judge for yourself: Bloomberg reported on July 20th that; “components of the index of leading economic indicators signaling the worst U.S. recession in five decades may be over now, not three to six months from now.” On July 10th, President Obama said that the “world has avoided economic disaster.” Barclays’ head of U.S. equity strategy, previously Wall Street’s most bearish stock strategies, now sees a stock market rally for the remainder of 2009.

Those who don’t learn from history …

The list goes on, but its core is this simple fact: bears are turning into bulls and bulls are turning into XL bulls. After decades of misinterpreting market indicators, Wall Street should know that new bull markets climb a wall of worry; they don’t ascent an escalator of hope.

Even Warren Buffett’s popular adage, about buying when others are greedy, or English Financier Rothschild’s well-known strategy to buy when there’s blood in the Streets, are ignored by many. The ignorance towards such time-tested words of wisdom will prove another adage correct once again: “Those who don’t learn from history are doomed to repeat it.”

Regardless, this “the worst is over attitude” is fueling the current rally in equities. Since Goldman Sachs’ pre-announcement last Monday, the S&P 500, Dow Jones and Nasdaq  have rallied between 5.5% to 7.5%, the biggest move in months.

Short-term, long-term outlook

Within the frame work of back-and forth wiggle action, the indexes are likely to claw their way to even higher highs, possibly as high as Dow 10,000. This doesn’t have to happen, but it’s possible.

Regardless of where the top will be, it will be the last time “this pitcher goes to the water.” Dow 10,000 is unlikely to be revisited for a long time. This roadmap for stocks is confirmed by four fundamental indicators with a track record of historic accuracy. Indicative of their implications, we call those indicators the “Four Horsemen.”

Unlike news reports and statistics - which provide a snapshot of current affairs, not a forecast – the four horsemen actually provide a forward looking roadmap for the stock market. The four horsemen consist of P/E ratios, dividend yields, mutual fund cash reserves and the Dow measured in the only true currency, gold.

By comparing current levels with readings reached during major historic market bottoms, one can actual calculate a range for the ultimate market bottom. Just as ice doesn’t thaw unless the temperature goes above 32 degrees, the stock market has never bottomed unless those indicators clock in at pre-defined levels.

The ETF Profit Strategy Newsletter includes a detailed analysis of the four horesemen along with a target range (points and time-frame) for the end of this rally and the ultimate market bottom. The only way to protect yourself from the law of averages is to foresee the unexpected.