Are your investment decisions based on emotions, or common sense and deductive reasoning?

To find out, we’ve listed a selection of facts that seem random, but ultimately might hold the key for the performance of various assets throughout 2010. Using deductive reasoning we’ll attempt to put the pieces together – like a puzzle – to create a big picture outlook for 2010.

Below are the facts:

- Last week, the S&P 500 (SNP: ^GSPC) and Dow Jones (DJI: ^DJI) reached new 52-week highs. The Nasdaq (Nasdaq: ^IXIC) did not.

- Last week, the Volatility Index (Chicago Options: ^VIX) fell to a 19-month low.

- Even though stock prices moved up, the first nine trading days of January 2010 sported the lowest average daily volume since 2003.

- Going into earnings season, stocks have rallied 70% from their March 2009 lows. Analysts expect 2010 earnings to be 23% higher than 2009.

- The U.S. dollar tumbled for most of 2009.

- Gold (NYSEArca: GLD) and silver (NYSEArca: SLV) rallied for most of 2009.

- Mortgage and credit card related losses for most U.S. banks (NYSEArca: KBE) were three times higher in 2009 than they were in 2008.

- Investors are nearly as optimistic about the future prospects of stocks as they were in late 2007.

- To investors, stocks are looking more attractive at Dow 10,000 than they did at Dow 7,000.

- China (NYSEArca: FXI) is expected to lead developed (NYSEArca: EFA) and emerging markets (NYSEArca: VWO) out of the slumps.

At first glance, there seems to be little correlation between all the above tidbits, but let’s try to make sense of them starting with one of the more obvious.

US dollar and stocks – a love-hate relationship

A falling U.S. dollar was the best prescription for the ailing U.S. economy. As the dollar falls, U.S.-made products become more affordable oversees, thus propelling sales of “made in USA.” Additionally, the falling greenback spurred carry trades where international investors borrowed U.S. dollars cheaply and bought U.S. stocks, making money on both transactions.

Less than 45 days ago, the whole world expected the dollar to drop into oblivion. Even central banks recommended stripping the dollar of its reserve currency status. At that time, the ETF Profit Strategy Newsletter wrote, “The U.S. Dollar Index has been bouncing around 75 for over a month now and seems to either have found or be close to a bottom.”

A few days later, on November 26, the US Dollar Index (NYSEArca: UUP) bottomed at 74.21. Since then, the greenback has rallied as high as 78.75, a huge move for any currency.

The chart above illustrates the near perfect inverse relationship between the U.S. dollar and the S&P 500 (NYSEArca: SPY). It also shows that the dollar has been setting the trend. The dollar peaked before stocks bottomed in late 2008 and in February/March 2009.

Now once again, the dollar has changed direction.  The rally from the November 26, 2009 low has taken the buck above resistance indicating that more upside is ahead. Upside for the dollar means downside for stocks. The question remains, is there a sound reason for the U.S. dollar to move up, and when will stocks follow this repelling lead?

Keep your dollars, they are precious

Conventional wisdom says that the government’s printing press is devaluing every dollar in circulation. Here’s an out of the box concept: Bloomberg reported that about $50 trillion of wealth was wiped out. Most of that wealth was denominated in U.S. dollars. It is probably that, despite the government’s injection of some $2 trillion, the amount of dollar denominated wealth has shrunk.

According to the recent earnings announcements by major banks, which reported that mortgage and credit card loan losses have tripled from 2008 to 2009, this trend is not yet over. With most of the toxic assets denominated in dollars, dollar wealth continues to shrink. As with any other asset, scarcity – or a lack of supply – results in higher prices. Quite likely, the U.S. dollar will continue to rally and put pressure on stock prices.

The worst is over, or is it?

Did you buy stocks in March when the Dow traded below 7,000? Why not? Did you buy stocks recently with the Dow at 10,000, if so, why? Doesn’t it make more sense to buy cheap and sell high than to buy high and hope for even higher prices?

In March 2009, most of Wall Street was afraid to see another Great Depression-like decline. In fact, Goldman Sachs lowered the earnings forecast for the S&P 500 companies by over 50%. But, stocks started to climb, and buying when everyone was selling would have been the right thing to do.

On March 2nd, the ETF Profit Strategy Newsletter issued a Trend Change Alert and recommended to close out short positions and start buying long and leveraged long positions. As per the Trend Change Alert, the Dow was expected to rally as high as 10,000. The end of the rally was to be recognized by extreme optimism and the sentiment that the worst is over.

This is certainly the case now. As the chart below shows, the Volatility Index (VIX), also called fear gauge, has reached the lowest level in 19 months. This means that investors have become complacent. There is no fear of a decline.

Market advisors polled by Investors Intelligence are more bullish today than they were in October 2007. Investors polled by the American Association of Investment Advisors have reduced their cash positions to levels not seen since early 2000. Both instances marked pivotal turning points in stock market history.

In March, the motto was to buy when others are selling. After a 70% rally and extreme optimism, investors should consider selling when everyone is buying.

The US dollar – lynchpin for gold and silver

As discussed above, the dollar’s rally is likely here to stay. What does that mean for gold and silver (NYSEArca: IAU)? A falling dollar aided the rise in precious metals; a rising dollar should do the opposite.

But how can gold go down with central banks around the world buying gold? The gold council reports that central banks went on a concerted gold-buying spree once before, in 1980. That was the year gold peaked at $850/oz. It took 28 years for gold prices to reclaim that level.

Conversely, central banks sold a net 4,800 tons since 1999, as prices tumbled to a 20-year low of $251.95/oz. Central bank’s timing track record is less than stellar. Pegging your financial future to the acumen (or lack thereof) of government actions might not be the best way to go.

The importance of gold

Regardless of its perceived value, gold, unlike fiat currency, does have intrinsic value and can’t be re-produced (or printed) at will. This makes gold a superior gauge of true value.

The Dow Jones is measured in fiat currency which can be, and has been, manipulated. As such, the Dow measured in dollars does not accurately reflect the real worth of the Dow and its components any longer.

To attain a true-value reading, it is helpful to measure the performance of the Dow Jones in gold. The Gold Dow reflects how many ounces of gold it takes to buy one share of the Dow Jones. Interestingly enough, the Gold Dow peaked in 1999 and has been declining ever since.

In fact, the Gold Dow knew that the rally to the 2007 stock market highs (as per the Dollar Dow) was disconnected from true value and would have to be corrected, sooner or later. For lack of a better illustration, you can compare the Gold Dow with the Kelly Blue Book. The Kelly Blue Book tracks the value of cars, the Gold Dow the real value of stocks.

Interestingly, the rally from the March lows never really registered with the Gold Dow. In fact, the Gold Dow has been stagnant for months and started to turn down a few weeks ago.

Connecting the dots

With a little bit of work and deductive reasoning, it is possible to make sense of a bunch of data that seems like random pieces of information. Common sense tells us that the Dollar Dow will soon follow the Gold Dow, and that today’s stock buying frenzy might be the selling opportunity of the decade.

The ETF Profit Strategy Newsletter includes a detailed analysis of the Gold Dow along with three other long-term indicators that have accumulated an impressive track record of historical accuracy. Knowledge about those indicators is like brain-food, while listening to Wall Street’s daily commentary is more like chicken-noodle soup for the soul. If you want to feel good today, follow your heart. If you want to profit tomorrow, follow your mind.