Credibility – everybody wants it, few have it, and once possessed it’s easy to lose. Credibility is as important as it is rare, particularly when it comes to investing and market forecasting.

A study conducted by the National Association for Business Economics shows that no fewer than 80% of professional economists believe the recession is over.

Such statistics seem credible, as do the polled economists. After all, many, if not most of them, went to Ivy League schools and should know what they’re talking about.

You may wonder, however, where were all the economists seven months ago in March? If anyone told you back then that the recession was over, you could have actually made some money. To declare the recession over now, is after the fact at best, premature at worst.

As the reasoning below will show, all humans, including sophisticated economist, the media, investors, the government, and Wall Street gurus are subject to peer pressure and crowd behavior, also called the herding effect.

Complex behavior – simple explanation

The herding effect could be explained in one sentence: If it’s too apparent, it’s apparently wrong.

Herding is a social behavior; in fact, it is a phenomenon that reflects a contagious emotional, collective feeling. This feeling (positive or negative) spreads among investors progressively. If this doesn’t make sense quite yet, hang in there – it will be the single most important contributor to your investment success.

Rather than explaining the herding effect with words, let’s take a look at a real life example.

Tech-bubble herding:

After two decades of relentless buying and unbridled enthusiasm surrounding the Nasdaq (Nasdaq: QQQQ) and technology sector (NYSEArca: XLK), 65.7% of individual investors (according to AAII) felt bullish about stocks in March 2000, while only 11.1% felt bearish.

Just about at that time, the Nasdaq (Nasdaq: ^IXIC) topped and started a steep decline.

Post 9-11 herding:

In October 2002, when the Dow Jones (NYSEArca: DIA) and S&P 500 (NYSEArca: SPY) traded around 7,500 and 800, only 24.5% of investors felt that stocks would go up, while 54.8% felt that stocks would drop further. It was exactly at that time that stocks bottomed. Even though this could have been a foundation for a huge rally, savvy investors knew that the 2002 low was doomed to be broken. (More about that later)

Financial bubble herding:

Leading up to the 2007 all-time highs, the Dow Jones (DJI: ^DJI) and S&P 500 Index (SNP: ^GSPC) rallied nearly 50% from the 2002 lows. On October 16, 2007 – right as the stock market peaked – bullish investors reached record levels of 54.6%. Bearish investors, soon to be redeemed, made up only 16.5%.

March market bottom herding:

Guess what happened in March 2009? Ranking at 18.9%, bullish investors were nearly non-existent. More than 70% of all investors had a bearish disposition. If you thought that professional investment advisors did better, consider the following: 47.20% of advisors thought stocks would drop further, while only 26.4% believed better times are ahead.

Knowing that, due to the herding mentality, investor pessimism climaxes at times of major market bottoms (and based on a composite of many other indicators), the ETF Profit Strategy Newsletter issued a Trend Change Alert on March 2nd.

This Trend Change alert predicted that the market was about to start the biggest rally since the 2007 all-time highs with gains of 40% and more. The target range given for a top of this rally was Dow 9,000 to 10,000.

At a time when investors wanted to sell and advisors told them to sell, the ETF Profit Strategy Newsletter said: “BUY!” and recommended broad market ETFs such as the iShares Russell 1000 (NYSEArca: IWB), iShares Russell 3000 (NYSEArca: IWV), sector ETFs such as the Financial Select Sector SPDRs (NYSEArca: XLF), Materials Select Sector SPDRs (NYSEArca: XLB) and high octane leveraged ETFs such Ultra Financial ProShares (NYSEArca: UYG), and Ultra S&P 500 ProShares (NYSEArca: SSO). All recommended ETFs have gained between 50% and 150%.

Herding – nobody cares until it’s too late

Truth often becomes distorted when emotions are involved. Depending on the environment (positive or negative) at the time, the same event may cause different emotions.

To illustrate: You are watching your favorite baseball team. The umpire makes an incorrect call, which negatively affects your team, but you don’t care too much because your team is winning. On the other hand, the umpire makes an incorrect, unfavorable call while your team is losing. Now you are ready to explode. Same event – different circumstances – different reaction.

There’s been much bad news about job losses, foreclosures, the next wave of defaulting loans, etc. But nobody cares because the market is going up. Going back to the above baseball illustration; you wouldn’t care about the umpire’s call as long as your team goes on to win, in fact you’d probably forget about it. If, on the other hand, your team goes on to lose, the loss will probably be linked to the umpire’s mistake.

So it goes with the stock market. Bad news doesn’t matter until stocks turn down. As we’ve seen in 2008 and early 2009, a bear market is the best auditor. Once the sentiment turns negative, it brings out news you wish could have been hidden forever.

The logical conclusion is that news feeds on itself. Good news usually climaxes towards a market top, while bad news reaches its crescendo at a market bottom.

As a mental exercise, think back to the second and third quarter of 2007. Wasn’t the general consensus that the market will continue to move up indefinitely? Conversely, think back six months ago when the Dow was below 7,000. How many people can you remember saying that the Dow would surpass the magic 10,000 level later in 2009?

Today’s investor sentiment

As discussed earlier, major market tops are usually marked by the majority of investors being bullish. In October 2007, 54.8% of investors and 62% of investment advisors were bullish. In August and October, as many as 51% of investors and 51.60% of investment advisors, were bullish. Keep in mind, though, that stocks are still 30% below 2007 levels and have just come off a 50% rally.

Why the 2002 market bottom did not last

The Dow Jones fell to 7,500 in October 2002. At the same time, P/E ratios hovered around 30, based on trailing (actual reported) 12-month earnings. Historically, a P/E ratio of 30 is over-valued.

The Dow Jones dropped below 6,500 in March 2009. On March 31st, the P/E ratio for the S&P 500 clocked in at 116. For the quarter ending on September 30th, Standard and Poor’s reported a P/E ratio of 138.

Anyone buying the S&P 500 at current prices is paying 138 times as much as reported earnings. In other words, based on this year’s earnings, it would take 138 years of profits to repay your investment.

How could savvy investors have known that the 2002 lows were not the bottom?

History teaches us that overvalued markets can’t last forever. History also teaches us how far the market will have to drop to reach fair values. The bear markets of the 1930s, 1940s, 1950s, 1970s, and 1980s have provided us with a valuation reset template.

Every bear market bottom has seen P/E ratios drop to historically low levels. Investors, however, don’t have to rely on P/E ratios alone. Dividend yields, mutual fund cash levels, and the Dow measured in the only true currency – gold (NYSEArca: GLD) provide another window into the future – a nearly fail-proof composite indictor.

The October issue of the ETF Profit Strategy Newsletter plots the historic performance of the stock market against P/E ratios, dividend yields, mutual fund cash reserves, and the Dow measured in gold, along with target levels for the ultimate market bottom. A picture paints a thousand words and those charts speak volumes about the market’s future.

When you hear the media, economists, or Wall Street in general talking about the new bull market, ask yourself, where were they seven months ago. It may be more rewarding to remember the trusted, long-term indicators that have graced Wall Street with their presence long before we made an appearance.