Seasonally speaking, December is one of the strongest months of the year. Among other seasonal factors, December often hosts the Santa Claus Rally, a set of generally positive trading days stretching from Christmas to New Year’s Day.

Recent market history shows that major indexes managed to eek out small gains in December 2006 and 2007. Even last year, amidst the 2008 meltdown, the Dow Jones (DJI: ^DJI) managed to record a 7.7% gain before the wheels came off in January.

But not all Decembers are created equal and more importantly, the market’s performance in the months leading up to December varies widely. The events leading up to December may be the key in determining how the year ends.

Stuck in a rut

Since November 9th, the S&P 500 (SNP: ^GSPC) has been confined to a tight trading range. For 29 consecutive trading days, the S&P has not been able to close more than 1% north or south of the 1,100 level. The same has more or less been true for the Nasdaq Composite (Nasdaq: ^IXIC) and Dow Jones Industrials (NYSEArca: DIA).

A look at the chart shows that the Wilshire 5000 (NYSEArca: IYY), the broadest measure of the U. S. stock market, hasn't made any net progress since October 15th.

Like a tight-lipped suspect under interrogation, the market has been stingy when it comes to giving up any clues about its near-term direction (even though the long-term trend is quite clear, more about that in a moment).

Just because the “suspect” won’t talk just yet, doesn’t mean all hope is lost. Like a resourceful investigator, investors can follow the evidence at hand to figure out what’s going on.

The evidence at hand

Like a snowmobile climbing up the slopes, the market has left track marks on its way to the current highs. Those markings are part of its track record and can play a part in determining what’s next. The track record shows that stocks have been reluctant to decline despite a steady flow of less-than-stellar news.

Even though this pattern will eventually fail, for right now it does remain intact. The question is for how much longer?

The most basic of indicators show that upside momentum is waning noticeably. Volume has been declining for weeks and once leading sectors like financials (NYSEArca: XLF), banks (NYSEArca: KBE), small caps (NYSEArca: IWM), and even mid cap stocks (NYSEArca: MDY) are now lagging large caps (NYSEArca: IWB). In fact, the only index to really attract new buyers is the Dow Jones Industrials.

The Dow has become for stocks what gold (NYSEArca: GLD) is for commodities – the focal point of all attention. When investors decide to commit new money to the safest of investments only, when stocks have rallied an unprecedented 65% in nine months, and when volume is drying up, red flags are raised. If a car starts to sputter after racing 500 miles without refueling, chances are it’s running out of gas. The question is, once the reserve light turns on, how much gas is left?

No progress but much change

Even though the S&P 500 (NYSEArca: SPY) has been stuck in the above-mentioned rut for over a month and has made no progress in terms of point gains, this range-bound churning has not failed to turn worried investors into complacent ones. The CBOE Volatility Index (Chicago Options: ^VIX), which measures option trader’s fear of a decline, has been declining steadily throughout November and December.

Since October 19th, when the S&P spiked above 1,100 for the first time in 2009, the percentage of stock market bears measured by Investors Intelligence has dropped from 23.10% to as low 16.50%. This is the lowest reading in over six years and does not bode well for a continuation of the bull market.

The percentage of bullish advisors jumped to 52.2%, the highest reading since December 2007. We all know what happened thereafter. The chart below shows the correlation between optimism and market tops.

A significant turning point accompanied by a revival of bullish sentiment was after last year's Santa Claus Rally, when stocks rose from December 23, 2008 to January 6, 2009. On December 15th, 2008, the ETF Profit Strategy Newsletter recommended in no uncertain terms that any reading above Dow 9,000 should be used as an opportunity to load up on short ETFs.

                              

From January 4th to the 6th, the Dow hovered above 9,000 before crashing. Dow 6,000 to 6,700, the target level for a market bottom given by the newsletter, soon went from ridicule to reality.

This holiday season the stakes are even higher. Going into December 2008, the major indexes had lost some 45% and were due for a sweet, but brief, counter trend bounce. This year, December caps off nine months and a 65% rally without any major correction. We all know that the market can’t rise indefinitely.

A sliver of hope for the bulls

As we’ll discuss in a moment, the long-term bearish case is well established. There is however potential for a short-term twist.

Just last Wednesday (12-9-09), the Investors Intelligence sentiment survey registered a 17-year extreme which might be a possible setup for the stock market’s final kiss good-bye.

Advisors classified as “correction” – in other words, advisors that are long-term bullish but expect a short-term correction – has spiked to 35.1%. This is the second consecutive week with the highest reading since March 1992.

While most investors are painfully aware that the market tends to do the opposite of what is expected, contrarian investors are cognizant that the 35.1% of advisors expecting a short-term correction will probably be proven wrong.

In short, the evidence to be drawn purely from sentiment readings points towards one more push up followed by some sort of a decline.

How bad can 2009 get?

While investors need to be resourceful to ascertain the short-term direction concerning U.S. equities, the U.S. indexes are quite “vocal” when it comes to the long-term outlook.

The book “This time is different,” published by the Princeton University Press, brings out that throughout history, rich and poor countries alike have been lending, borrowing, crashing – and recovering – their way through an extraordinary range of financial crises. Each time, the experts have chimed, “this time is different” – claiming that the old rules of valuation no longer apply and that the new situation bears little similarity to history. 

Well, this time is really no different. Rather than conceding that stocks are overvalued, the recovery has been dubbed a jobless or a statistical recovery implying that the old rules of valuation no longer apply, even though history shows that’s never been the case.

Rather than believing in a freak event that’s never happened before, wouldn’t it make sense to evaluate reliable patterns of history and use those as financial roadmap?

Boring but true

Here’s what history shows, plain and simple: 1) At times, the perceived value of stocks may disconnect from their intrinsic value, but 2) At no time does such a condition persist indefinitely. The market always brings the perceived value down to the real value. What is the real value?

A company’s value to its shareholders is measured by the ability to generate profits and pass those on to its shareholders. The higher the profits the more investors are willing to pay for the company’s shares. If there are no profits, investors are better off putting their hard earned dollars elsewhere.

This principle applies to individual companies as well as indexes and the entire stock market. Currently the S&P 500 trades at 88 times current earnings. This means, it would take the S&P constituents on average 88 years to repay the money investors have loaned them by buying their shares. Historically, that number is between 10 and 25. In other words, the P/E ratio for the S&P 500 sits right now at 88, an all-time high.

How about dividends? At no other time have dividends been cut faster than in 2008 and 2009. In fact, dividend yields are close to their all-time lows, which were seen in 1999 – right before the tech bubble burst.

Even though it seems clear that stocks are overvalued, Wall Street would like us to believe that this time is different. Unfortunately it’s not.

Investors can chose to believe Wall Street and the economists – the same ones who didn’t see the 2000 or 2007 crash coming – who’ve proclaimed the recession is already over or open their eyes and see.

The November issue of the ETF Profit Strategy Newsletter includes a detailed analysis of P/E ratios dividend yields, mutual fund cash levels and other indicators and plots them against historic and current prices. Based on those trusted parameters, a target range for the ultimate market bottom, and even a top for this rally are given.

Soon we will see if this time will be different.