I know what you’re thinking. Is he really combining two different early 90’s movies into an article title? That’s pushing the limits of clickbait. Fair enough, but hear me out. It will hopefully make some sense by the end of this piece.

In late May, I took you “Back in Time,” writing about the many similarities between 2007 and 2014. In July, I wrote of the continuing parallels in “Back to the Future Part II“. In that piece I reminded investors that in 2007 stocks finished higher on the year and did not ultimately peak until October. However, I cautioned: “whether investors knew it at the time or not, they were incurring a very high risk for only a few percent reward that year.”

It’s hard to believe but October is here. Do the parallels to 2007 still exist? Let’s go back in time to October 2007 and find out.

It’s October 2007. The S&P 500 is up over 9% on the year and investors are broadly optimistic as the Bull Market is five years old and headlines featuring “new all-time highs” are seemingly everywhere.

Meanwhile, the intermarket action is telling a different story, with the defensive Utilities sector outperforming while Consumer Discretionary, Banks and Housing names are lagging.

We’re also seeing a noticeable divergence between the S&P 500 (large caps) and Russell 2000 (small caps) with the latter underperforming. In the third quarter, the S&P 500 would finish higher, masking broader weakness as the Russell 2000 declined.

The credit markets are also sending a different signal than the S&P 500 with high yield credit spreads wider on the year, well above their June lows.

Collectively this is highly defensive behavior and while the broad market is largely ignoring it, the risk/reward is clearly changing.

Back to October 2014 and we are seeing a very similar backdrop. The bull market is over five years old, it has been over two years since there has been a sizable pullback, and we seem to read about “new all-time highs” in the S&P 500 every day.

Given this backdrop, like October 2007, investor sentiment is extremely optimistic.

However, while the large cap indices remain strong, the intermarket action is considerably weaker. Just as was the case in October 2007, the defensive Utilities are outperforming while the cyclical Consumer Discretionary, Banks, and Homebuilders are all lagging.

As I have been writing about for much of the year (click here for most recent piece), we are also seeing a massive divergence between small caps and large caps. Last quarter, we saw small caps decline while large caps advanced. Where have we seen this before? That’s right, we were just there. This was the first time this occurred since the third quarter of 2007.

In the credit markets we are starting to see signs of weakness as well. Like 2007, spreads bottomed in June and are wider on the year here in early October.

The Hunt For Red October

As was the case in October 2007, on the surface all is calm today. But unfortunately, this is not the only similarity between the two periods. Lurking underneath the surface, like the submarine Red October, are potentially dangerous divergences in cyclical sector weakness, small cap weakness, and junk bond weakness.

Collectively, these signals are sending a warning sign to markets: after five years of gains, the risk/reward is changing, and not for the better.

It remains to be seen how the rest of the year plays out and whether this leads to a run-of-the-mill correction or something more. Most seem to be assuming that it will lead to nothing as that has been the case thus far in 2014 (see “The Bear Who Cried Wolf”). For those looking for an exact replica of 2007 for this analysis to be valid, you will surely be disappointed. It will most certainly be different today than 2007 as it is never exactly the same.

What is the same, though, is the fact that underlying conditions have weakened, and as long as they persist, the odds favor a more defensive posture. I realize that is not as alluring as someone picking an exact time and date top, but it is the best we can do in markets. Defense or offense – what are you more focused on today?

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.