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False Breakout?

Today, investors reacted negatively to disappointing fourth-quarter earnings from large retailers and raised concerns about the strength of US consumers.


Investors will focus on economic numbers coming out this week, including minutes from the last FOMC minutes (Wed), the second revision to GDP (Thurs), and January’s Personal Consumption Expenditures (Fri).


The S&P 500 index (SPX) slipped further below its trading support at 4,060.79 (2/10/23 low) and now tests crucial support at 3,941.5-3,992 (50-day ma, 200-day ma, Oct 2022 uptrend, the extension of the Aug 2022 downtrend breakout, and the bottom of the Bollinger bands).

After breaking out of the Aug 2022 downtrend (4,027 -1/26/23) and setting a higher high (4,101 - 2/1/23), the lack of follow-through to the breakout is troublesome. The 2/17/23 gap-down and the abrupt reversal below the previous breakout levels (4,101/4,027) warn of the potential for a false breakout.


An oversold rally within a primary downtrend tends to be explosive but is not sustainable. It entices buyers to buy on emotion, fearing they have missed the trade before abruptly reversing direction.


A false breakout is what it sounds like – a breakout that failed to follow through beyond the level of the breakout. A false breakout is a contrarian move in the market that provides early clues the price trend may soon change direction or that the trend is resuming soon.


A false breakout often occurs when aggressive traders or weak hands enter the marketplace chasing an extended rally. The price reversal tends to flush out these traders who entered the market looking for a quick trade.


So, how will we know if this is a false breakout?


False breakouts can occur in different market environments, including trending markets, sideways markets, and primary and secondary trends. It is crucial to monitor the market closely in the days and weeks following the break out as the market actions can offer clues to an impending directional trend change.


The lack of a follow-through beyond the breakout is often the first warning that something is wrong. However, the experienced trader will wait for further signs, including evaluating how the market reacts near a pullback toward pivotal support.


The current pullback nears this pivotal support, coinciding with key moving averages, the uptrend line, the extension of a previous breakout, the bottom of Bollinger bands, and the volume-by-price (VBP) bars between 3,950-4,000.


If SPX breaks below the 50-day and 200-day moving averages and the Oct 2022 uptrend, this may signal the end of the Oct 2022 oversold rally, resulting in a sharp decline to 3,764.5-3,784 (Dec 2022 low and the Nov/Dec 2022 trendline). A breakdown further reaffirms the end to the mid-Oct 2022 oversold rally, leading to a retest of the 10/13/22 reaction low (3,491.58).


On the other hand, if SPX maintains above pivotal support at 3,941.5-3,992 and rallies above 4,194.44 (2/2/23 high), this signals the resumption of the Oct 2022 oversold rally and a retest of the Aug 2022 reaction high (4,325.28).


Source: Chart courtesy of StockCharts.com

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