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Drozd: Two-month reversal forewarns livestock producers to higher meal prices

The meal market was technically oversold which created the opportunity for a short covering rally

Sometimes it just does not pay to ignore what the charts are telling you.

Case in point, soybean meal futures exploded higher after a two-month reversal materialized on the monthly nearby futures chart.

This reversal pattern indicated a change in trend and is illustrated in the accompanying chart. Since its development on March 31, the nearby soybean meal futures have rallied US$150 per ton, with barely a pause, as futures have settled higher in each of the past eight weeks.

Two-month reversal

A two-month reversal develops when on the first month the market advances to new lows for the move and closes very weak near the low of the month. The following month, prices open unchanged to slightly lower, but cannot make additional downside progress. Quantity buying appears early in the month to halt the descent and prices begin to turn up. By month’s end, the market rallies to around the preceding month’s high and closes at or near that level.

Market psychology

The two-month reversal is an absolute change in sentiment.

On the first month, at market lows, the shorts are comfortable and confident. As the market declines, it provides encouragement and reinforces the expectation of greater profits. Shorts are market participants who have sold a futures contract in anticipation of profiting on the futures market trending lower.

The second month’s activity is a complete turnaround from the preceding month and shakes the confidence of many who are still short the market. The immediate outlook for prices is abruptly put in question.

Suddenly, and without hesitation, a dramatic shift in psychology drives the shorts to cover (buy back) their positions. They find they have plenty of company, as potential new longs also want in.

When the market turns around, the motivation to preserve profits quickly takes hold. Without news to explain the soybean meal market’s strength, the shorts may at first misjudge the turn as being merely a bounce within the downtrend. With profits on the books, the tendency is to wait and see what happens, which turns out to be a huge mistake. The market is propelled higher by aggressive new longs and suddenly the race is on with the shorts trying to make the best of a rapidly deteriorating position.

When the soybean meal market rallied after the May 10 USDA supply-and-demand report, many of the shorts were left dumbfounded by the US$20-per-ton limit up daily move in soybean meal futures. This price explosion was caused when buy stops were triggered above the May 3 high.

The shorts place buy stops above key areas of resistance in order to take profit or cut losses on a short position. However, longs could also be using buy stops to enter the market or to add to their existing profitable long positions. As the market rallies and these buy stops are triggered, they become a buy-at-the-market order, which drives futures higher. In this frenzied environment, nothing else matters. It is simply the flow of money driving futures higher.

Well after the turn, the fundamentals do change to substantiate the reason for higher prices.

However, from a technical vantage point, this meal market was technically oversold and therein stood the possibility for a short covering rally. As I often exclaim, “the news is always the most bearish at the bottom and having an understanding of technical analysis is a way for you to cut through the bearish news.”

Livestock producers who recognized this, were able to manage their risk and secured their meal requirements before the market turned around and shot up US$150 per ton.

Send your questions or comments about this article and chart to [email protected].

About the author

Columnist

David Drozd is president and senior market analyst for Winnipeg-based Ag-Chieve Corporation. The opinions expressed are those of the writer and are solely intended to assist readers with a better understanding of technical analysis. Visit Ag-Chieve online at www.ag-chieve.ca for information about our grain-marketing advisory service and to see our latest grain market analysis.

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