On March 9th, the Wall Street Journal ran an article titled “Dow 5,000? There’s A Case For It.” The Dow (DJI: ^DJI) bottomed that very day at 6,440, along with the S&P 500 (SNP: ^GSPC) and Nasdaq (Nasdaq: ^IXIC), and went on to rally for seven consecutive months.

Fast forward to September 17th, when the Wall Street Journal ran an article titled “The Dow Will Hit 10,000 Soon. So What?” It’s too soon to say with certainty that the market has topped, but we can already see that the Dow has dropped several hundred points since then and has yet to ring the 10,000 bell.

Admittedly, using the Wall Street Journal’s prowess (or lack thereof) in forecasting market trends is not the most academically correct gauge.  Nevertheless, it illustrates how the financial media tends to jump on a trend wholeheartedly just before it reverses (more about that in a moment). Needless to say, this causes much anguish, irritation, and losses for investors.

Unlike the Wall Street Journal and Wall Street in general – which was stuck in a self-pity party around the March lows – the ETF Profit Strategy Newsletter went against the grain and sent out a Trend Change Alert on March 2nd.

The arrival of this alert in subscriber’s e-mail boxes was no surprise, as the newsletter had already predicted a bottom below Dow 6,700 earlier in 2009. The Trend Change Alert predicted a persistent and powerful multi-month rally that would push the Dow Jones (NYSEArca: DIA) into the 9,000 – 10,000 range.

ETFs recommended included plain vanilla ETFs like the S&P 500 SPDRs (NYSEArca: SPY), Nasdaq (Nasdaq: QQQQ) and Vanguard Total Stock Market ETF (NYSEArca: VTI). Sector ETFs like the Financial Select Sector SPDRs (NYSEArca: XLF), Vanguard Materials (NYSEArca: VAW) and iShares DJ U.S. Consumer Services (NYSEArca: IYC), along with leveraged ETFs such as the Ultra Dow Jones ProShares (NYSEArca: DDM) and Ultra Nasdaq ProShares (NYSEArca: QLD) were also included.

Trend-chasers - the blind leading the blind

We’ve seen in 2007 and 2009 that blindly following the so-called expert advice coming from Wall Street and the media, enticed investors to buy towards a market top and sell towards a market bottom.

To create a blind leading the blind scenario, two components have to be in place. You need a “blind” entity or group of people willing to lead, and another willing to follow. We all know the end result of the blind leading the blind – they both fall into a pit – so why would anyone follow a blind leader? In short, it’s all about perception. Perceived leadership qualities and a subsequent vortex of peer pressure often persuade even the smartest of individuals to follow a blind leader.

Before we discuss the applicability of this phenomenon for the average Joe, let’s take a moment to illustrate the basic concept of blind faith. Imagine you are rich. Imagine all your friends are rich. Imagine your friends tell you about an investment guru who will double your money every five years without any risk.

Obviously you are suspicious and want to ask questions. This suspicion, however, makes you appear unintelligent towards your friends because they’ve been doubling their money for years. In fact, they’ve done you a favor by introducing you to their guru who accepts clients by invitation only.

You’ve been given a once in a life-time opportunity and would be a moron if you turned it down. Peer pressure outweighs your gut, ‘it-sounds-to-good-to-be-true’, feeling; you are now ready to start doubling your money without risk, too. Can’t happen you say. It did happen; ask all the sophisticated investors who lost millions with Bernie Madoff.

The obvious, yet effective, bait-and switch

The money-losing cycle for the average Joe investor and even educated money managers, starts with the financial media. As the Wall Street Journal headline (Dow 5,000? There’s A Case For It) shows, the media was expecting even lower prices following the March lows.

As stocks rallied, the mood of the media lightened up as well. The surge in optimism from the March lows to the September highs happened in baby steps. Initially, in March and April there were signs that the government stimulus might be working.

This was followed by rare green shoots. A bit later, fertilized by rising stock prices, green shoots were popping up all over the place. Even higher stock prices brought about the notion of a jobless recovery. Wall Street now believes that the green shoots have matured into full blown plants. The recovery is here to stay, they say.

All the yo-yos, who never saw the 2007 meltdown coming and thought things would get even worse in March, are saying that the bear market is over and the V-shaped recovery is well under way. Where were they when we needed them?

Buy stocks at your own peril

The chart below shows how the percentage of bullish advisors hit rock-bottom during the March lows and inclined – along with rising prices – ever since. Bullishness tends to piggy back on rising stocks, until extreme bullishness, all of a sudden, becomes a contrarian indicator.

The ETF Profit Strategy Newsletter had warned of the elevated levels of optimism seen earlier in January and recommended to buy short ETFs, such as the UltraShort Financial ProShares (NYSEArca: SKF) and UltraShort S&P 500 ProShares (NYSEArca: SDS). Following the secondary January highs, stock prices plummeted 30% in 90 days.

Ironically as it may seem, extreme levels of bullishness becomes like a noose around the neck of the very bulls supporting that trend. 

The psychology of market down-trends

Extreme levels of optimism reflect the morphosis from wanna-be stock buyers to owners. When owners outweigh potential buyers, the pipeline of new buyers dries up to a point where there's not enough buying volume to drive up prices any further. This is compounded by the fact that owners are reduced to either holding or selling, neither of which can propel prices.

As the base of stock owners has become un-proportionately high, an impending down-trend is inevitable. Profit taking will get the stone rolling. As prices start to decline, more stops will be triggered and selling will become the new trend. The unusual high level of stock ownership provides a consistent flow of stocks being put up for sale, resulting in rapidly declining prices.

In August and September, the Investors Intelligence survey of investment advisors, registered the highest levels of optimism seen since the 2007 all-time market high. Such levels are almost always indicative of lower prices to come. The scope of optimism suggests that significantly lower prices are looming on the horizon.

This interpretation of investor sentiment is confirmed by valuation metrics with a track record of historic accuracy.

Overvalued is an understatement

There are different ways to determine the stock markets real value. P/E ratios and dividend yields are the most commonly used valuation metrics.

The chart above reveals two key factors:
1) Based on P/E ratios, the stock market is grossly overvalued, even at current prices. As per Standard & Poor’s research, the preliminary Q2 2009 P/E ratio is 140.76 (99% of companies have already reported).
Historically, a P/E ratio north of 20 is viewed as expensive. Historically, there is almost a 70% chance of correction after P/E levels spike above 25 – 30. Imagine the impact of a 140 P/E ratio.

2) The chart clearly shows that the stock market does not bottom unless P/E ratios completely reset (indicated by the red line). This was true in the 40s, 50s, 70s and 80s. In 2002 valuations were not reset. As we now know, the 2002 lows did not last. Earlier this year, valuations were not reset either. The implications are clear.

Just as ice does not thaw unless temperatures rise above 32 degrees, the stock market does not bottom unless P/E ratios (and dividend yields) fall below the reset levels, which in turn triggers a sustainable rally.

Based on the extreme sentiment readings, it is unlikely that the Dow Jones will grind beyond 10,000 for a significant period of time. Even if there was a brief spike above 10,000, based on long-term valuation metrics, there is no reason to expect Dow 10,000 or anything even close to that level, over the long-run.

How low do stocks have to drop before a real bottom and fair valuations can be found? The ETF Profit Strategy Newsletter contains a detailed analysis of P/E ratios, dividend yields, investor sentiment and the Dow measured in the only true currency – gold – along with a target level for the ultimate market bottom and weekly guidance through the stock market’s long journey ahead.