About a week ago, Wall Street's focus was on just how well financial companies a la Goldman Sachs, JP Morgan, Bank of America, and others have done last year when it comes to making profits.

Even though many financial institutions’ bottom line numbers may have had a closer connection to financial engineering than reality, they still disappointed. One bad week for financials (and the market) had erased several months worth of gains.

Before the carnage started, on January 12, 2010, the ETF Profit Strategy Newsletter (via its Weekly ETF Pick) recommended picking up shares of the UltraShort Financial ProShares (NYSEArca: SKF). SKF is an inverse fund that aims to deliver twice the inverse, daily performance of the financial sector.

Below are headlines that describe what is happening with the financial (NYSEArca: XLF) and banking sector:

“Bank of America reports Q4 loss” – Reuters, January 20, 2010
"Mortgage pain persists for BofA and Wells" – Reuters, January 20, 2010
"Morgan Stanley pays up though profit disappoints" – Reuters 20, 2010
"Goldman trims pay, post profits as shares fall" – Reuters, January 21, 2010

Leading up to the January 19th closing highs, investors should have heeded the old council, 'Buy the rumor and sell the news.'

The actual earnings results delivered the sizzle, when investors were looking for the steak.

Today, Pfizer, the world’s biggest drug maker, said profits missed analyst estimates. Again, all sizzle, no steak! The Health Care Select Sector SPDRs (NYSEArca: XLV) are down half as much as Pfizer itself.

How long can you live off the sizzle?

There was certainly much sizzle going into earnings season. Much of the news was already baked in.

According to analysts polled by Barron's and Bloomberg, combined earnings for the S&P 500 companies are expected to jump 23% to $73.69 a share in 2010, from $59.82 in 2009. As the chart below shows, even rising earnings per share (EPS) do not guarantee a rising market.

Some analysts, like JP Morgan's chief strategist Lee, predict that S&P 500 profits will clock in at $80 a share.

Don't trust earnings estimates

Earnings estimates are by no means guaranteed. In fact, analysts reserve and exercise the right to modify their estimates at a whim. In March 2009, as the Dow (NYSEArca: DIA) was approaching 7,000, Goldman Sachs and many others went on record forecasting falling estimates.

On March 9th, 2009, the very day the major indexes a la Dow Jones (DJI: ^DJI), S&P 500 (SNP: ^GSPC) and Nasdaq (Nasdaq: ^IXIC) bottomed, the Wall Street Journal reported that Goldman Sachs had revised their previous forecast of $64 a share to $40 share.                                        

Contrary to Wall Street's wisdom, the ETF Profit Strategy Newsletter issued a buy signal via the March 2nd Trend Change Alert. The Trend Change Alert recommended closing out previously held short ETFs and to start buying long and leveraged long ETFs, such as the Ultra Dow Jones ProShares (NYSEArca: DDM), Ultra Financial ProShares (NYSEArca: UYG), and many others.

The top of this rally was predicted to occur somewhere close to Dow 10,000 at a time when optimism is rampant and 'the worst is over feeling' sets in.

2010 will be better than 2009 – or will it?

The overwhelming consent is certainly that the worst is over. Early in January, optimism had reached levels not seen in years, even decades. How can optimism be measured?

Investors Intelligence tracks the recommendation of different market advisors. In early January, 53.4% of all advisors were bullish. 30.7% of advisors were longer term bullish, but believe a short-term correction is likely. All together, 84.1% of advisors expected higher prices. Even the October 2007 market highs did not elicit such a positive response.

How about retail investors? According to the American Association of Individual Investors (AAII), investors are only keeping 18% of their money in cash. This is the lowest level since April 2000.

It is important to connect the dots when talking about investor sentiment. The last extreme reading of market advisors occurred on October 15th, 2007, within less than a week of the all-time market top. Thereafter, the broad stock market fell (NYSEArca: VTI) 55%. Real Estate (NYSEArca: IYR) and financials led the charge lower.                        

The last time investors felt comfortable enough to keep only 18% of their money in safe cash was in the very early stages of the tech-crash. Within a year, the Technology Select Sector SPDRs (NYSEArca: XLK) and Nasdaq (Nasdaq: QQQQ) had lost more than half of their money.

No doubt, the optimism surrounding this year's earnings announcement (at least initially) was decisively bearish to the astute investor. In the past, when earnings season was greeted by extreme optimism, the S&P 500  was 2 - 3 times more likely to go down than up. The maximum performance to the downside trumped the upside by more than 2x.

Optimism means lower prices

On January 15, 2010, two trading days before the closing highs were reached, the ETF Profit Strategy Newsletter made the bold statement: “Bullish sentiment has reached a level where it is suffocating nearly all bearish currents and undertones. The natural reaction would be, and has been by most, to conform to the trend, join the crowded trade and turn bullish. Historically, such extreme optimism leads to market declines. Even though the up-trend has lasted longer than expected, we believe that every day that brings higher prices presents a better opportunity for the bears”

Slowly but surely, euphoria is starting to be replaced by skepticism. If major corporations make little or no profit, how do you put a price tag on their stock? Where is their fair value?

Are stocks cheap?

The Standard and Poor's P/E ratio for the S&P 500, based on actually reported earnings, is 84.30. This means it would take any S&P constituent an average of 84.3 years to repay the money it borrowed from investors. This does not include interest. How willing would you be to offer a business loan payable over 84.3 years at no interest?

Of course, the P/E ratio falls if you compare the current price with expected earnings. But as we've learned above, Wall Street has a tendency to go with the flow when it comes to earnings. The flow right now is not up.

In March, when things looked bad, Wall Street expected things to get worse. A few weeks ago, when things looked good (after a 70% rally), Wall Street expected things to get better. With earnings disappointing, but still expected to rise another 23%, analysts might once again be forced to revise their forecast – after the fact.

What’s next for stocks?

Different valuation metrics are the markets built in temperature gauge. When things heat up, the market is forced to cool down - this means lower prices.

Historically, the market is 'healthy' with a P/E ratio around 15. Based on actual earnings (P/E of 84.3) the market is overvalued by more than five times. Using a more 'conservative' methodology, the S&P 500 (NYSEArca: SPY) on a normalized Shiller P/E basis, is overvalued by close to 30%.                                           

P/E ratios are not the only valuation metric, however. Dividend yields and the Dow measured in real money - gold (NYSEArca: GLD) are others.

All major market bottoms over the past 100 years had one thing in common; LOW P/E ratios and HIGH dividend yields. What we are witnessing right now, is exactly the opposite. That's not what a sustainable bull market is made of.

A look at the Dow Jones measured in gold shows just how overvalued stocks denominated in U.S. dollars (aka Dow Jones) have become. Indicative of their implications, we've dubbed the composite indicators consisting of P/E ratios, dividend yields, the Gold-Dow, and mutual fund cash levels as the 'Four Horsemen.'

The ETF Profit Strategy Newsletter contains details of the 'Four Horsemen,' plotting stock market prices and each indicator individually against historic market bottoms, along with a short, mid and long-term forecast that includes the target range for the ultimate market bottom.