On Thursday the S&P 500 broke down from a triangle formation, which is a kind of continuation pattern. Continuation patterns are so named because, when the pattern ends, prices are normally expected to continue in the direction they were trending before the continuation pattern (consolidation) began. In this case, the breakdown was not what was expected, and puts a bearish shade on a picture that been bullish since the October low.
A positive aspect to the price breakdown is that a number of ultra-short-term indicators hit climactic oversold readings the same day. On the chart below we can see how these oversold spikes generally coincide with the start of rallies of at least short-term duration.
Climaxes are a sign of either initiation or exhaustion. An initiation climax signals that price will begin moving in the direction of the climax, while an exhaustion climax occurs at the end of a move. Immediately following a climax, prices can chop around for a day or two before the followthrough begins.
The question, of course, is what kind of initiation is this one? With an intermediate-term buy signal in effect, we look for a bullish interpretation, which would be that the breakdown was actually a shakeout, intended to turn people bearish just ahead of a rally. Unfortunately, we are still on a long-term sell signal, which means things could be about to get nasty again.
Another negative is that intermediate-term indicators (see chart below) are still overbought and need to move to at least the neutral zone. As you can see on the chart, this can happen without accompanying price deterioration about half the time.
Bottom Line: The market just failed a test by breaking down out of the triangle formation, but the technical damage is not serious, and a decline to the 1175 area to clear intermediate-term overbought conditions could be absorbed without major technical damage being done. On the other hand, if the ultra-short-term oversold spikes have produced sufficient internal compression, yesterday's breakdown could prove to be the final shakeout preceeding a new rally. In any case I view the recent decline as a correction within the rally that began in October.
