As January goes, so goes the year, is an old Wall Street adage that’s been proven right more often than wrong. 

Those who wish to get a head start on their 2010 forecasting tend to look at the first-five days of the January barometer. This pattern has a success rate of 80%+ over the past 38 years. The success rate drops to 50% when looking just at the past two years.

During the first five trading days of 2010, the Dow Jones (DJI: ^DJI) inched up 1.82%, the S&P 500 (SNP: ^GSPC) climbed 2.68%, while the Nasdaq (Nasdaq: ^IXIC) moved up 2.12%. Based on the first five days, this should be a good year.

Wall Street analysts will tell you the same thing. In fact, according to polls conducted by Barron’s and Bloomberg, analysts expect the S&P 500 (NYSEArca: SPY) to gain 12% in 2010.

Investors Intelligence, which tracks the recommendations of newsletter writers and financial advisors, reported on December 29th that a record low of only 15.6% of advisors had a bearish outlook for stocks. This is the lowest reading in over 22 years.

Smooth sailing or calm before the storm?

Wall Street and Main Street obviously believe that the administration averted a deeper economic bruising. Time Magazine’s selection of Ben Bernanke as 2009’s “Man of the Year” attests to the deeply ingrained conviction that the worst is over. Never before has a Federal Reserve chairman received this title.

Traders in general and options traders in particular have also reached a level of complacency that hasn’t been seen in over 19 months. The last time we saw the VIX (Chicago Options: ^VIX) as low as today, was in May 2008.

At that time, investors’ lack of fear proved to be a pivotal turning point for U.S. (NYSEArca: VTI) and international stocks (NYSEArca: EFA). From May to July, the Dow Jones (NYSEArca: DIA) lost 2,000 points. After a brief two month period of respite, the Dow went on to lose another 3,500 points.

Extreme bullishness and complacency is certainly not bullish for the market. As a matter of fact, such bullish extremes are one of the most reliable contrarian indicators of an impending correction. How big of a correction? We’ll discuss that in a moment.

What will trigger a correction?

Rather than asking what will trigger a correction, we should ask what would push the market higher. Last Friday’s unemployment numbers disappointed; yet stocks inched higher.

Economic news dispersed over the past few months has been a mixed bag, yet stocks moved higher. What’s next in line to push up stocks; earnings season?

Alcoa’s (NYSE: AA) quarterly report signals the beginning of this earnings season. Excluding special items, earnings of a penny a share came in below analyst’s expectations of six cents. This is despite a weak U.S. dollar, which is commonly viewed as an advantage for international companies. AA stocks sold off as much as 5% on Monday after the close.

After being revised several times (revised meaning lowered), Q4 estimates for the S&P 500 are $13.47. This is lower than the actual Q3 numbers of $13.51. With expectations at such low levels, it would be a surprise to see no earnings surprises.

But will earnings surprises be enough to lift stocks? Conventional wisdom says yes. The chart below plots the quarterly reported earnings of the S&P 500 (Q4 2009 is an estimate) against the performance of the S&P 500. Even though there’s a correlation between the two, earnings do not always drive the stock market.

In fact, a look at the chart above (years 2000, 2002, 2007 and 2008) shows that stocks can and will decline parallel to rising earnings.

Trouble in paradise

Investors willing to take off their blinders have been noticing the disconnect between the economy’s true state and the stock market’s performance. The economy continues to worsen while stocks continue to rally.

A recent Bloomberg report further emphasizes this disconnect. “Analysts say earnings at financial companies rose 120% in the fourth quarter, accounting for all of the income increase in the Standard & Poor’s 500 Index, and will triple by 2010, climbing four times as fast as the market. Should the estimates prove correct, the shares are trading at a 15% discount to the index, data compiled by Bloomberg shows.”

Exactly where bank’s profits are coming from, we are not privy to know. What we do know is that banks were able to boost their capital ratio by changing their accounting standards (June 2009 issue of the ETF Profit Strategy Newsletter, page 2). William Black, a former bank regulator, considers this type of financial engineering a way to “exchange trash for cash and turn real losses into faulty gains.”

It seems like the rift between too good to be true banks (also known as too big to fail) and smaller regional banks (NYSEArca: KRE) is becoming more and more pronounced. Major banks (NYSEArca: KBE) and financial institutions (NYSEArca: XLF) expect strong profit gains while smaller banks continue to close shop.

The Wall Street Journal reported that the Federal Deposit Insurance Corp. (FDIC) is having trouble finding buyers for many of the 130+ banks it seized in 2009. Even though the Fed may agree to cover loan losses, banks are in such poor shape that potential purchasers simply cannot be persuaded to bite.

Should you buy the rumor, sell the news?

Buying the rumor and selling the news is an old piece of Wall Street wisdom, which refers to the fact that the market tends to price in positive news before it becomes public. A stock will often stage a rally leading up to its earnings announcement and sell off thereafter, even if the earnings were positive.

On a broader scale, the stock market may already have priced in better than expected earnings, increasing profits and decreasing unemployment numbers. After all, stocks have rallied nearly 70% in less than ten months, possibly mortgaging the future growth potential.

With the S&P recording five new recovery highs in each of the last five days, a slowing of the uptrend is not visible to the casual observer. Investors willing to take off the blinders, however, will notice that volume and breadth has been declining to a point that’s worrisome.

Last week, options traders (considered to be notoriously wrong) bought 2.5 times more call options (betting on a rising market) than put options (betting on a falling market). This is the highest ratio since the year 2000. That year the tech-bubble burst (NYSEArca: XLK) and the Nasdaq (Nasdaq: ^IXIC) tumbled 37%.

Y2K – more than just tech

While the tech-bust might be the most well-known event of the year 2000, it is certainly not the most significant. Another index, the only index that measures true value, topped in the year 2000 as well – the Dow Jones measured in gold (NYSEArca: GLD).

The Dow measured in gold reflects how many ounces of gold one share of the Dow is worth. This unique ratio allows investors to evaluate stocks priced in the only currency that hasn’t been tampered with, the only true store of value – gold.

The Dow gold peaked in the year 2000 and has been declining ever since. Even as the dollar Dow, and most other indexes, rallied to new highs in 2007, the gold Dow did not, foreshadowing trouble ahead. Today, the dollar Dow is rallying again. The gold Dow is not.

Of course, the gold Dow is not the only way to measure true value. There are other metrics, all of which point towards significantly lower prices. Indicative of their implications, the ETF Profit Strategy Newsletter has dubbed them the “Four Horsemen.”

The Four Horsemen are not short-term timing tools, but they provide a reliable long-term outlook. In context, and in comparison with the long-term outlook, it becomes easy to distinguish counter trend rallies from true new bull markets.

Many on Wall Street believe we’ve entered a new bull market. The Four Horsemen, however, beg to differ. Wall Street’s track record in forecasting the market is less than stellar, otherwise we would have heard warnings in 2007 and buy signals in March 2009, but we did not.

Using the Four Horsemen along with other indicators, the ETF Profit Strategy Newsletter was able to identify the October 2008 meltdown and the rally from the March lows. Each issue of the newsletter includes a short, mid and long-term forecast (including a target range for the ultimate market bottom) and corresponding ETF profit strategies.