Discernment is probably one of the least talked about and most under rated attribute of successful investors. Discernment is defined as the ability to grasp what’s not evident or obvious to the average mind.

This implies that discerning investors have to look beyond the general train of thought, or perception, to attain a balanced and educated opinion.

What’s obvious

The major U.S. benchmarks a la S&P 500 (SNP: ^GSPC), Dow Jones (DJI: ^DJI) and Nasdaq (Nasdaq: ^IXIC) have rallied 60% and more since their respective March lows. Consequently, stocks are more expensive today than they were eight months ago.

Ironically, more investors are willing to buy stocks at Dow 10,000 than they were at Dow 7,000. The same economists who didn’t see the March market bottom or 2007 market top coming, are now telling us that the recession is over. Even though the irony therein should be obvious, it’s hardly publicized.

Good for Wall Street – bad for investors

That’s good for the economists, bad for the average investor. In fact, it is probably this type of short-term memory loss on the side of investors (and economists), that makes Wall Street what it is – a lounging place for trend chasers.

Bucking the trend has proved profitable to subscribers of the ETF Profit Strategy Newsletter. After predicting a market bottom below Dow 6,700, the newsletter sent out a Trend Change Alert on March 2nd, at a time when Wall Street was in panic mode, to prepare subscribers for the upcoming rally.

This rally was expected to be the biggest rally since the October 2007 all-time highs. Recommended ETFs included plain index ETFs such as the Dow Diamonds (NYSEArca: DIA), S&P SPDRs (NYSEArca: SPY), iShares Russell 1000 (NYSEArca: IWB) and iShares Russell 2000 (NYSEArca: IWM), sector ETFs such as the Financial Select Sector SPDRs (NYSEArca: XLF), dividend ETFs such as the Dow Jones Dividend ETF (NYSEArca: DVY) and SPDR S&P Dividend ETF (NYSEArca: SDY) and leveraged ETFs such as the Ultra S&P 500 ProShares (NYSEArca: UYG), or Ultra Financial ProShares (NYSEArca: SKF).

However, there are times to follow the trend and there are times to go against it. Getting caught on the wrong side can prove costly. Valuation metrics are one way to discern the long-term trend. The long-term trend is always more important since tomorrow’s long-term gains can easily erase today’s short-term losses.

P/E ratio does not equal P/E ratio

Since it simply measures a company’s profitability compared to its stock price, the price to earnings (P/E) ratio is one of the easiest and most accepted valuation tools.

What is not commonly known though, is that there are different ways to calculate P/E ratios. Not all roads lead to the same P/E ratio.  In fact, just as an object’s length expressed in centimeters is different than the same object’s length expressed in inches, P/E ratios of the same index or company will vary depending on the methodology used as a foundation for the calculation.

To explore the various approaches we have to get a bit technical, but hang in there, it’ll be well worth your time and ultimately help you increase profits or reduce losses.

The P/E ratio is attained by the interaction between two variables, price and earnings. The price is always obvious and easily determined by a look at the chart. Earnings are not. There are different methods to calculate earnings. The final P/E ratio depends on which two of the following four components are used as a foundation:

1) Operating earnings
2) Reported earnings
3) Top down analysis
4) Bottom up analysis

Explaining the four components

Operating earnings:
Operating earnings include income from the sale of goods and services. Not included as cost are expenses related to marketing, layoffs, financing, M&A. Operating earnings tend to be higher as corporations “omit” expenses that have to be included for reported earnings. Higher or inflated earnings result in artificially lowered P/E ratio.

Reported earnings:
Reported earnings are based on the generally accepted accounting principles (GAAP), which provides a “cookie-cutter” type earnings report that allows for an apples to apples comparison between companies and does not allow companies to omit unfavorable factors.

Bottom up estimates:
Bottom up estimates are based on the individual earnings from each company. The estimates are put together from the consensus returns published by individual stock analysts. Adding up individual earnings numbers, yields earnings for indexes or sectors.

Top down estimates:
Top down is an estimate of earnings based on the broad economic indicators such as GPD growth, inflation, interest rates, etc. From there, economist’s forecasts are narrowed down to sectors or markets. Top down forecasts tend to result in lower P/E ratios.

P/E ratios based on top down operating earnings tend to be at the lower end of the spectrum, while P/E ratios based on bottom up reported earnings tend to be on the higher end. Additionally, the P/E ratio can be based on projected earnings. A P/E ratio based on projected 2010 earnings would be lower than a P/E ratio based on actual 2009 earnings, since earnings are expected to increase.

The up-to-date numbers listed on Standard and Poor’s website for top down operating earnings P/E ratio is 27.75 (the highest reading since 2002) and 85.55 for top down as reported earnings (the highest ever).

Future projections – wishful thinking?

Year-to-date reported earnings for the S&P came in at $36.09. Top down estimates for 2010 are north of $80. As mentioned above, top down earnings are distilled based on broad economic data such as GDP.

Even though preliminary Q3 2009 GDP clocked in at 3.5%, due to lower than expected retail sales, the trade deficit and other factors, the actual GDP was lowered to 2.8% a few days ago.

This GDP revision will also result in a revised top down P/E ratio and P/E ratios based on projected numbers. As you can see, using P/E ratios based on projections is futile. Why add an extra variable to a business that is already in enough flux.

Rather than gambling with projected numbers, the ETF Profit Strategy Newsletter has consistently been using actual, reported data.

How to profit with P/E ratios

Now that we’ve gotten all the technical mumbo-jumbo out of the way, let’s get back to the basics.

Regardless of which P/E ratio you choose to use, P/E ratios and by extension stocks are grossly overvalued. As the chart below shows, P/E ratios have reached levels never seen before. Notice the red line titled “valuation reset.”

No bear market has ever ended unless P/E ratios dropped below the valuation reset level. Never before has the spread been greater between P/E ratios and the market bottom level.

Using other valuation measures, such as dividend yields and the Dow measured in the only true currency – gold (NYSEArca: GLD), in conjunction with other major bear market bottoms, one can actually calculate a target range for the ultimate market bottom.

The Dow measured in gold provides us with a glimpse of what lies ahead. Observe how the red line – the Gold Dow – has declined steadily ever since its 1999 high. The dollar Dow should soon follow.

The November issue of the ETF Profit Strategy Newsletter includes a detailed analysis of P/E ratios, dividend yields, mutual fund cash reserves, and the Dow measured in gold along with target levels for a short-term market top and long-term market bottom.

Indicative of the implications, those four indicators have been dubbed the “Four Horsemen.” The discerning investor will understand the significance of the four horsemen.