A hunter sets traps in places where he can catch unsuspecting animals. Whether a bird catcher or a bear hunter, traps are usually hidden and catch their prey by surprise. It’s a time-proven formula.

The same is true with the stock market. The market never announces its intention to the masses. The market works in a way where it tries (and usually succeeds) in separating as many people as possible from their hard earned dollars. Using bear market traps and fake counter trend rallies that stir up unfounded hope, is one strategy.

Beware of Trojan Horses

Explaining the 10% rally from the July lows at Dow (DJI: ^DJI) 9,614, S&P (SNP: ^GSPC) 1,011, and Nasdaq (Nasdaq: ^IXIC) 2,061, the ETF Profit Strategy Newsletter noted on July 16: “The market is now trying to appease investors alienated by the recent 17% drop, baiting them to return to a fully invested status. This rally should turn out to be a Trojan Horse. Once enough investors jump back on the rally bandwagon, the train will switch directions and head directly to the next low. The bear market train likes each wagon to be packed with unsuspecting victims.”

It took a while for investors to bite. On August 11, the percentage of bearish advisors and newsletter-writing colleagues surveyed by Investors Intelligence, showed the biggest decline since February 23. Right on cue, the U.S. equity market fell about 3% that day and 7% since.

Know Who to Trust

A rising tide lifts all boats. A rising market certainly gets everybody excited. On August 2, when the S&P closed at 1,125, we found the following headlines:

MarketWatch: “Dow 14,000 in 2011? Cabot letter explains how”
MarketWatch: “Why August is for market optimists”
MarketWatch: “Investor sentiment gets hotter in July”
Bloomberg: “U.S. economy improving, more stimulus isn’t the answer”
Bloomberg: “Bernanke says U.S. consumer spending to accelerate”

Obviously, investors can’t rely on the media for solid investment insight. The media is like a friend who tells you not to worry about rain and then offers you an umbrella after you are soaked from the storm that wasn’t supposed to come.

Beware of False Breakouts

At times, the market’s performance even turns technical indicators bullish. A hard and fast interpretation of purely technical analysis would lead investors straight into the bear market trap.

On July 26 for example, the S&P closed once again above the 200-day moving average. A Bloomberg headline read: “Dow Erasing 2010 slump as S&P 500 index tops 200-day average fuels bulls.” Also on that day, the ETF Profit Strategy Newsletter stressed not to lose sight of the bigger picture:

“According to purely technical analysis, the trend is at the cusp of changing from down to up. This technical point of view is supported by today’s close of the S&P above the 200-day SMA and the Dow Theory bullish confirmation. However, our analysis shows that it is not uncommon for counter trend rallies of larger degree to persuade even technical indicators to move into bullish territory. In fact, we see the same kind of disconnect between fundaments and the market’s performance today, as we saw throughout March and April 2010. If stocks don’t turn around here, odds favor a move into the 1,131 – 1,140 cluster outlined yesterday.”

After a few more days of sideways trading, the S&P moved as high as 1,129 before dropping nearly 100 points. Even though the financial (NYSEArca: XLF), technology (NYSEArca: XLK), materials (NYSEArca: IYM), consumer discretionary (NYSEArca: IYC), industrials (NYSEArca: IYJ), utilities (NYSEArca: IDU), small caps (NYSEArca: IWM), and mid caps (NYSEArca: IWR) traded temporarily above the 200-day MA, the downtrend was not broken.

Diversify your Thinking

As the above examination of the 200-day MA shows, it is not prudent to rely on the rigorous interpretation of just one indicator. When buying a car, you don’t just rely on the manufacturer’s biased description; you check consumer reports and other independent resources to formulate a well-rounded opinion, right?

The same holds true for investing, it wouldn’t be prudent to only rely on Wall Street’s propaganda or a single indicator. Knowledge is power, and the more knowledge you have, the more powerful your investment strategy will become.

Mulligans for Life

There are no Mulligans (do-overs) in investing. There are, however, ways to minimize losses. One of the Investor’s Business Daily cardinal rules is to use 7-8% stop losses. This limits losses but may get you stopped out of a profitable long-term investment at the wrong time.

Another strategy is to get the market’s long-term direction right. If you are wrong in the short-term but right in the long-term, your investment will eventually be profitable. In other words, never invest against the long-term trend. If the trend is down, don’t buy stocks. It’s like traveling from A to B. If you know where B is and you have enough gas in the tank, you will arrive at B even if there are detours.

Long-Term Outlook

How do you determine “B” or the long-term destination for stocks? Perception and valuations are the two main driving forces behind any tradable asset. While perception is ultimately tied to valuations, it can diverge for periods of time. But, eventually, valuations always revert to the mean.

This valuations cycle that goes from overvaluation to fair valuation, and not to forget undervaluation (such is in the 1930s), is as perpetual and reliable as the water cycle.

Asset bubbles happen when perception deviates too far from actual valuations. Of course, Wall Street always comes up with reasons why the old parameters of valuations don’t apply anymore and why things are different this time.

However, things are not different. In fact, the 2000 tech bubble, 2006 real estate bubble, and 2008 financial bubble are recent proof of just how reliable the valuations cycle is.

Until recently, it was believed that the 50% + drop from the 2007 highs to the 2009 lows, automatically returned stocks to fair valuations and set the foundation for a new bull market. But were fair valuations really reached in March 2009?

Here’s what the Wall Street Journal wrote in a March 9, 2009 article: “Looking solely at valuations, name price relative to earnings estimates, the S&P at 500 isn’t necessarily a wild stretch.”

Pure Logic

As per Standard & Poor’s, the P/E ratio based on reported earnings was 116.31 on 3-31-2009. At the time, this was at an all time high. Based on P/E ratios, at the 2009 lows, the S&P was more overvalued than at any other time in history. That’s not what market bottoms are made of.

If there was no valuation reset in 2009, there was no lasting market bottom. If there was no lasting market bottom, the rally since the March 2009 lows is nothing more than a counter trend rally. Does this mean that the March 2009 lows are in danger? Yes.

The ETF Profit Strategy Newsletter features a detailed analysis of four different valuation metrics (due to their implications we’ve dubbed them the “Four Horsemen”), along with short, mid and long-term forecasts and a target range for the ultimate market bottom.

Even the best bear market trap won’t work if you are aware of what lies ahead.