Bullish Trend Change Signal
On Friday the July 2016 bean oil/corn spread ended the week with a close above the declining 50-day Moving Average for the first time in three and a half months. This triggered an entry signal for the blog, so a hypothetical long position was initiated at -$2,760.50 (premium corn). Initially, we will risk a two-day close below -$4,279 ($200 below the September 15th contract low).
We’ve got a couple of things working in our favor here. Fundamentally, the trend change signal occurred after the USDA crop report. For the second month in a row, the government lowered their expectations for the size of the US bean crop. Fewer soybeans usually means less bean oil. Although the corn crop forecast was revised downward as well, it was not quite as much as expected. In addition, the USDA raised their yield estimates for corn. This could have provided a fundamental catalyst for the bean oil to start outperforming corn on a relative basis.
Technically, the close above the 50-day MA shows a shift in the price trend. The last time this occurred, the July 2016 bean oil/corn spread surged to nearly +$1,100 (premium bean oil). Furthermore, the spread made what we call a Wash & Rinse pattern when it cracked support at the mid-July low and then promptly reversed. This failed bearish breakout pattern can often precede significant rallies.
Statistically, the upward reversal has good probabilities of a continuation since it follows a breakdown below -$4k in the spread and a drop to in the ratio to 0.8:1. Both of these levels are historically infrequent and have always been followed by major reversals to the upside.
Whether or not the trend change signal will work this time is left to be seen. Sometimes it takes a few attempts before the trend change actually sticks. But we do know where the history of where the bean oil/corn spread has gone to after a dip into oversold territory. This allows us to set a target of where we expect this thing to go.
After the bean oil/corn spread hit the second-lowest price of the last four decades in 2012, the spread rebounded to +$3,800 (premium bean oil) over the next two years. This was the lowest rebound level to follow a drop near -$4k or lower. Prior recoveries sent the spread to nearly +$6,900 in 1977, approximately +$5,350 in 1985, and +$4,750 in 1998. Therefore, a minimum target of +$4k seems reasonable.
From another angle, our minimum recovery target for the bean oil/corn ratio is 1.35:1. Looking at the prior instances where the ratio dropped to 0.8:1 or lower, the 2014 recovery to nearly 1.21:1 was the lowest level it reached. Prior recoveries from 0.8:1 or lower pushed the ratio to 1.49:1 in 1974, 1.55:1 in 1977, 1.39:1 in 1985, nearly 1.44:1 in 1988 (the ratio had ‘only’ dropped to just under 0.81:1 prior to that, but it’s close enough to our target to be useful), 1.59:1 in 1998, and 1.48:1 in 2003.
These targets are based on the macro timeframe. Don’t expect them to be hit in the next few weeks. History shows that, barring an extreme event like a drought, it takes time to reach these levels. The good news, however, is that it could provide traders with plenty of opportunities to add to long positions as the trend progresses. If we see any interesting setups along the way, we will be sure to let you know.