Lean Hog/Corn Spread
History shows that the price of hogs and the price of corn are highly-correlated. Fundamentally, this is due to the fact that grain feed prices represent somewhere between two-thirds to eighty percent of the cost of production in the hog business.
If the cost of production (corn price) is low hog producers have a chance for a better profit margin. This can cause an increase in supply. Conversely, high feed price will reduce profit margin. Un-hedged producers will then typically scale back operations and reduce market supply.
Therefore, the hog/corn ratio is an important figure to watch. The ratio is used as a historical gauge to predict where hog supplies will be twelve to eighteen months out in the future. Watching the ratio between hogs and corn can yield a much clearer picture and, accordingly, a much better trading result than watching the price of hogs and corn on their own.
Hog/Corn Ratio Price Parameters
The ratio between 100 lbs. of hogs and one bushel of corn is normally between 22:1 and 25:1. Over the last half century, whenever the ratio has neared 32:1 or higher it inevitably peaked and came back down. Perhaps it is due to the fact that the profit margin over 30:1 is so large that hog farmers produce as much as they can. This ultimately leads to a supply glut and a price reversal.
On the flipside, there is also a pain threshold for the hog/corn ratio. Historically, a decline below 15:1 usually causes major herd liquidation in the hog industry as the profit margin evaporates. There have only been about half a dozen different occasions in the last forty years when the ratio plunged below 15:1 on the closest futures prices. Every time this occurred, the ratio ultimately reversed and went back to a minimum of 24:1 or higher…sometimes substantially higher.
It is interesting to note that the handful of times where the nearest-futures ratio reached 32:1 or higher it collapsed to 15:1 or lower a year or two after the final top was established. The ratio did not just revert to the mean, it overshot by a wide margin. It seems that the ratio behaves like a pendulum that swings from one extreme to the other.
On the monthly nearest-futures chart, the hog/corn ratio finished the month of September at a nine and a half year high of 33.6:1. Therefore, it seems likely that a blow-off stage has been reached. The hog/corn ratio could continue to scream (squeal?) higher from here, but history indicates that it is reaching the last stage of a bull market. A wicked multi-month decline should eventually follow.
The Hog/Corn Futures Spread
Normally, a hog/corn futures spread position is implemented at a ratio of 2:1. This is because it is roughly estimated that it takes about one 5,000 bushel contract of corn to feed the equivalent of two 40,000 lb. contracts of lean hogs. However, hogs hit an all-time high this year while corn fell on its ear and hit a five-year low just this week. This catapulted the spread between two hog contracts and one corn contract into the stratosphere and makes a 2:1 spread position heavily-weighted to the hogs. Therefore, we will simplify things by looking at the spread between the values of one 40,000 lb. lean hog futures contract and one 5,000 bushel corn futures contract.
Today one April 2015 lean hog contract is worth about $19,500 more than one May 2015 corn contract. Over the last four decades, the spread between the value of one 40,000 lb. lean hog contract and one 5,000 bushel corn contract usually oscillates around +$10K (premium hogs). Sometimes the spread dips below +$5k and sometimes it spikes above +$15k, but it always find its way back to the +$10K area.
Historically, spreads priced above +$15k have been infrequent and have never lasted. In more than four decades of price history, there are only half a dozen times when the nearest-futures hog/corn spread has surpassed +$15k on the nearest-futures chart. No matter how long it stayed elevated, it ultimately collapsed and went all the way down to +$1k or lower.
In July of this year, the nearest-futures hog/corn spread posted an all-time high of $33,132.50 on the weekly timeframe. Ultimately, this should be setting the foundation for a major bear market decline.
Good Fortune…Or Misfortune?
Currently, the April-May hog/corn spread is trading right above the July 22nd contract high that preceded a $5k pullback into mid-August. You will notice that the July top for the April-May hog/corn spread is significantly lower than the July top for the nearest-futures spread. This is due to the fact that hogs were in backwardation as strong demand pushed the closer delivery contracts up substantially higher than the longer-dated delivery contracts. In addition, corn is in a normal carry-charge market where the longer-dated delivery contracts trade at a premium over the near-term contracts.
On the one hand, a trader looking for a short sale setup might be disappointed that the April-May hog/corn spread is not trading at a premium that’s nearly as frothy as what the summer spreads were. Nonetheless, the April-May spread is still well above the +$15k mark that has historically provided profitable short sale trading opportunities.
On the other hand, the April-May hog/corn spread is testing the important July top where a double top could form and usher in a bear market or else the spread could breakout and go racing toward the nearest-futures summer peak near +$33k. A trader willing to follow the trend in either direction sees that the spread has the potential for a move of at least $13k, up or down.
If a trader has both the capital and the intestinal fortitude, a reversal system could be employed. By ‘reversal system’ we mean one where a position is always in the market, long or short, and never flat. You simply determine the trade parameters to signal when to be long and when to switch to short and then follow it mechanically.
Trend Change Signals
There at least three possible signals that traders can use to identify a possible bearish trend change for the April-May hog/corn spread:
First, a close below the rising 30-day Moving Average (currently around +18,188) for the first time since late August could signal a trend change. The breakout above the 30-day MA at the end of April correctly identified the run to the July peak, the close below the 30-day MA in early August indicated a bearish trend change, and the close back above the 30-day MA in late August signaled that the uptrend had resumed.
Second, a close below the September low of +$16,897.50 would alter the price structure. Over the last six months, there has only been one time where the April-May hog/corn spread has broken a prior month’s low. Another such event, especially after returning to the contract high, could be indicative of a bearish trend change.
Third, a close below the rising weekly 15-bar Moving Average (likely somewhere around +17,560 when next week begins) for the first time since the spring could signal a trend change. The pullback into mid-August stopped just above the weekly 15-bar MA, so it appears structurally valid for the current uptrend.
For tracking purposes, the blog will hypothetically implement a reversal system for the hog/corn spread with a position consisting of one 40,000 lb. April 2015 lean hog contract and one 5,000 bushel May 2015 corn contract. A long position (long hogs and short corn) will be initiated on a close above +$20k and a short position (short hogs and long corn) will be initiated on a close below +$18k. Each price level will act as a stop and reverse point. For example, if a long position is entered on a close above +$20k then a close below +$18k will trigger a signal to liquidate the long position and initiate a short position. If a short position is entered on a close below +$18k then a close above +$20k will trigger a signal to liquidate the short position and initiate a long position. Hang on to your hats because it could be a wild ride!