Sometimes, doing the smart thing is not always the profitable thing. On the flip side, making a profitable move is not always the smart decision.

There is a formula for outperforming the market and making money when others don’t. Even though this formula may fail you at times over the short-term, it delivers impressively over the long term.

Dare to be different

The pillar of this success formula is to do the opposite of what everyone else is doing. This is of course easier said than done. How do you know what everyone else is doing? And how do you know when you should dare to be different?

The financial media and financial analysts provide a general gauge of what investors are thinking. When headlines and financial outlooks are overly optimistic, a warning siren should go off.

We’ve seen such an overly optimistic outlook in 2007 when both the media and analysts projected a strong 2008. The year 2000 was no different.  But the ones making money in the subsequent years were those who did the opposite of what most were doing.

In 2000, technology (NYSEArca: XLK) tumbled. In 2008, financials (NYSEArca: XLF) tumbled. Also in 2008, the media led you to believe that the world is running out of oil (NYSEArca: USO). What happened to oil? From it’s 2008 high to its 2009 low, oil prices fell by more than 70%.

If you are in-tune to what’s going on, you are thinking, wait a minute, just a few weeks ago everyone thought that stocks would rally throughout 2010. Nearly all Wall Street analysts expected gains north of 10% for 2010. Isn’t that a sell signal?

A January to remember

That’s correct. Investors were as bullish in January as they have been in years, even decades.

In December 2009 and January 2010, Investors Intelligence (II) reported a record low of only 15.6% and 15.9% of bearish advisors, the lowest reading since 1987.

Conversely, on January 19th, II reported 575 buying climaxes, the second highest reading of the past three years. A buying climax takes place when a stock makes a 12-month high, but closes the week with a loss. They are a sign of distribution and indicate that stocks are moving from strong hands to weak hands. Ironically, January 19th marked the high of 2010. We’ll discuss in a moment whether this high is here to stay or not.

On January 16th, the ETF Profit Strategy Newsletter referred to this extreme optimism and stated the following: “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. We believe that every day that brings higher prices presents a better opportunity for the bears.”

A few days later the major indexes a la Dow Jones (DJI: ^DJI), S&P 500 (SNP: ^GSPC) and Nasdaq (Nasdaq: ^IXIC) tumbled more than 7% in a matter of days, the steepest decline in well over seven months. It only took a few days to erase nearly three months worth of gains.

No straight line

No market, however, falls without counter rallies. The February 4th ETF Profit Strategy Market Meter said that nothing goes down in one swift move, and odds that some bounce to the upside will develop sooner or later are increasing.”

The S&P 500 (NYSEArca: SPY) has now closed up 7 of the past 8 sessions (e-mini futures), setting up an opportunity for the bears. Why?

As the chart below shows, the market has been rising on light volume and falling on heavy volume. Volume leading up to the January 19th high was the lowest in years and picked up throughout the decline. The rally of the February 8th low came once again on low volume, sometimes not even breaking above 1 billion shares traded on the NYSE.

Short-term vs. long-term

While volume data provides a clue, it is certainly no fail-proof indicator and does not provide any conclusive long-term guidance. You can’t tell by looking at volume data whether the market is in for a protracted decline or just a short-lived correction.

Buying climaxes, as discussed earlier, provide a subtle hint that investors are losing faith in the market’s ability to climb. Stocks moving from strong hands to weak hands after recording a 52-week high, is generally bearish.

Even though the recent decline has once again illuminated reality, there is still a disconnect between stock prices and what’s really going on.

After closing more than 140 banks in 2009, the FDIC was forced to close 20 banks in 2010. Simultaneously, the SPDR KBW Regional Banking ETF (NYSEArca: KRE) has rallied to new highs. The SPDR KBW Bank ETF (NYSEArca: KBE) is not far behind.

Even though the real unemployment rate is 18% (Real Unemployment 18 Percent - Will Stocks Falter?), the recovery has been termed a “jobless recovery.” How can the economy grow if consumers aren’t spending and companies dependent on discretionary spending (NYSEArca: XLY) can’t turn a profit? Spending on consumer staples (NYSEArca: XLP) and a general sense of frugality can’t propel an economy.

Investors Business Daily reported that the percentage of loans that were in foreclosure or behind at least one payment hit 15.02%, the most since the Mortgage Bankers Association (MBA) record began in 1972. Analysts expect foreclosures to remain high.

How can the economy, small caps (NYSEArca: IWM), mid caps (NYSEArca: MDY) and large caps (NYSEArca: VV) recover if real estate (NYSEArca: IYR), the root of the problem, continues to deteriorate?

The one-two punch

All the above concerns are significant, but the biggest problem should be valuations.

If you’ve ever bid for an item on EBay, you know that anything up for auction is worth as much as its perceived value. The perceived value, however, can and does change. You may for example get less for a Toyota Prius today than you did a couple of months ago. The car is still the same, but consumers have now become aware of a flaw which makes it less attractive.

This flaw for stocks would be valuations. While this goes largely ignored as long as investors are chasing stocks, the fear of paying too much spreads like cancer once it takes hold – this is called the herding effect which caused investors to gobble up stocks in 2000 and 2007 and also moved investors to sell at any price throughout 2008.

Historically, the stock market is always overvalued and never bottomed unless P/E ratios hit rock bottom – rock bottom is way below current levels. Based on reliable historic parameters, the stock market is grossly overvalued and not even close to a bottom.

Dividends are another measure of value. Healthy dividend yields reflect a healthy economy. Current dividend yields are anemic and offer no hope of capital preservation. The Dow measured in the only true currency – gold (NYSEArca: GLD), mutual fund cash levels, 2,000-day moving averages, and many other indicators point to the same conclusion – lower prices.

The November issue of the ETF Profit Strategy Newsletter includes a detailed analysis of all the above mentioned indicators plotted against the historic performance of the Dow Jones. A picture paints more than a thousand words, and the picture painted by these indicators is certainly worth viewing and much more reliable than any piece of daily economic news.

Every issue of the ETF Profit Strategy Newsletter includes a detailed short, mid and long-term outlook for all major asset classes, along with specific target levels and ETF profit strategies. It's time to turn analysis paralysis into profitable investment strategies.