Take a look at what transpired in the middle of 2012. The Federal Reserve met rapidly falling spreads head on, jolting “risk on” investing behavior via open-ended quantitative easing stimulus (QE3). Right now? Investors are exhibiting the kind of “risk off” preferences that transpired back in mid-2012. Yet the Fed is not gearing up to provide additional liquidity. On the contrary. Fed committee members seem resigned to raising borrowing costs, if ever so slightly.

The narrowing between 30-year maturities and 2-years demonstrates a similar “risk off” pattern. The spread is even lower than when the Fed shocked and awed the investing world with QE3.

 

The declining spreads and the flattening of the yield curve are a sign of risk aversion – one that, historically, has worked its way into stocks. If the current pattern of yield curve flattening continues, equity prices of popular benchmarks are likely to fall.

2. Narrowing of Stock Breadth

According to Bespoke Research, the top 1% of Russell 3,000 stocks (30 largest) are up roughly 6.6% YTD. That is the top 1%. The other 99%? The remaining 99% of Russell 3,000 stocks have averaged a decline of -3.0% YTD.

Others have identified the lack of participation using the S&P 500 SPDR Trust (SPY). The top 20 components have gained 59% while the other 480 components are collectively down 3.0% YTD. The result for the market-cap weighted ETF? A 3% gain.

Historically, narrow breadth rarely bodes well for the intermediate- to longer-term well-being of market-cap weighted funds. A better picture of what is actually happening to risk preferences is evident in equal-weighted proxies like the Guggenheim Russell 1000 Equal Weight ETF (EWRI). We can see that, much like the NYSE itself, EWRI is still close to 7% below its May high; EWRI is still trading at a lower price than when the Fed exited QE for good with its final mortgage-backed bond purchase on 12/18/2014.

EWRI Similiar to NYSE

 

Similar to stock valuations, weak breadth may not matter until it does. Thin leadership where a few stocks carry the entire load can become even thinner leadership. Historically, however, the top 1% or the top 5% tend to buckle. That’s why it is sensible to ask one’s self, is it likely that the other 95% or the other 99% will join the top 1% or top 5% at extremely overvalued price levels? Or is it more likely that profit-taking on stocks like Facebook (FB), Amazon (AMZN) and Netflix (NFLX) will result in a take-down of the heralded S&P 500?

For the majority of my moderate growth and income clients, I maintain a 60% stock (mostly large-cap domestic), 25% bond (mostly investment grade) and 15% cash/cash equivalent mix. This contrasts with a more typical “risk on” allocation of 65%-70% stock (e.g. large, small, foreign, etc.) 30%-35% bond (e.g. investment grade, convertible, high yield, foreign bond, etc.).

Top stock ETF holdings include the iShares MSCI USA Minimum Volatility ETF(NYSEARCA:USMV), the Technology Select Sector SPDR ETF(NYSEARCA:XLK) and iShares S&P 500 (IVV). Top bond holdings include Vanguard Total Bond Market ETF(NYSEARCA:BND) as well as the iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF).