Still Riding the Bear
The feeder/corn spread topped out at a historic high fifteen months ago. Since then, IMC has been in and out of this spread on the short side as we’ve tried to capitalize on the bear market.
The normal ratio between a 50,000 lb. feeder cattle contract and a 5,000 bushel corn contract is somewhere around 3:1. It peaked at a record high of nearly 7.5:1 in Q4 of 2014 and has been stair-stepping its way lower ever since. In nearly half a century of price data, there have been about half a dozen times when the nearest-futures feeder/corn ratio has been at 4.8:1 (nearly five-to-one) or higher. The prior runs to this level have ultimately been followed by a return to 3:1 or lower. Therefore, we continue to look for short sale opportunities as the trend progresses on a south-bound trajectory.
Ready to Roll
After posting a new contract low in mid-December, the feeder/corn ratio made a sharp rebound into year-end. It was due to a combination punch of the rally in livestock, prompted by position-squaring of short positions and cold weather finally arriving in the US, and the corn market falling on its ear as concerns of El Niño fade away while supplies remain abundant. The momentum is continuing here in the first trading week of 2016.
The bearish macro fundamentals remain in place. After the US drought wiped out supplies and sent the cattle market stampeding to record highs, cow herds started to expand again in 2015. This is expected to continue in 2016, while US exports are already at multi-year lows and imports are at multi-year highs.
On the feed side of the spread, corn prices have pretty much been in a trading range over the last year. Large supplies have capped the upside, but demand has materialized several times when the market dipped below $3.50-per-bushel.
This scenario makes us think that this recent price recovery in the spread is merely a bear market rally and, therefore, a selling opportunity.
Consulting the Charts
From a technical perspective, the recent price action indicates that the bounce is now testing resistance levels.
Over the last three years, the best way to make money in the feeder cattle (basis the nearest-futures) was to be long on a long on a close above the 50-day Moving average and short on a close below the 50-day Moving average. This trend reversal signal has been highly accurate.
After a bearish trend change signal was triggered last June, the 50-day MA has provided resistance for feeders. The 21.65 cent bounce off the October low ended after the market tagged the 50-day MA. A decline to new bear market lows followed. Currently, feeders have rallied a little over 26 cents off the December low and they are pushing on the 50-day MA. A reversal from here would be a low-risk selling opportunity. However, a two-day close above the 50-day MA for the first time since June would trigger a bullish trend change signal. This should not be ignored. We’ll let the market tell us if we should get short or not.
April feeders have made higher weekly highs for three consecutive weeks and it is now approaching the Fibonacci .618 retracement of the leg down from the October bounce. If the contract does not trade to 158.45 or lower by Friday, this will also be the third consecutive week with higher weekly lows. This is turning into bullish price structure. However, a break below a prior week’s low would negate that and indicate that the bear market in feeders is continuing. A break below a prior week’s low might be a good short sale signal. It certainly worked out that way after the rally crested in October.
The nearest-futures corn contract dropped to a four-month low of $3.50 1/4 to kick off the New Year. This puts it within striking distance of price support in the $3.40s. The market bottomed in this area in May, June, August, and September of 2015, so it represents the bottom of a trading range.
The catch is that we’re watching the May futures contract for the trade. May corn has made new contract lows in three of the last four weeks as it bleeds off the carry-charge. It may also make lower weekly highs for the fourth-consecutive week. This is bearish price structure. Therefore, it might take a breakout above a prior week’s high to indicate that corn is ready to pop again.
Now that we’ve taken a peek at the feeder market and the corn market, the next logical step is to examine the price action of the spread and the ratio.
The April-May feeder/corn (x5) spread traded just past the October peak this morning. So far, the spread has rallied a little more than $16,000 off the contract low. This was noticeably more than the $11,487.50 rally from the early October low, but not quite as much as the $18,437.50 rally off the mid-July low. Based on the size of the current rally and the price level, we can probably say that the spread has reached a resistance area. If it rolls over from here, especially after testing resistance at the prior bounce high, a short sale makes sense. If it does not roll over, the spread may advance toward psychological resistance at the ‘even money’ mark next.
The April-May feeder/corn ratio reached a two-month high of 4.61:1, putting it just below the October peak at 4.65:1. The bounce is about the same size as the bounce from the mid-July low. This is an ideal place for a reversal. Conversely, a sustained close above 4.65:1 could clear the way for a stampede toward the August high of 5.12:1. Our thoughts remain consistent: Short the spread if it starts to roll over, stay patiently on the sidelines if it does not. Once we get back in, we’ll be looking for setups to add to the position.
The blog will work a hypothetical order to sell one 50,000 lb. April feeder cattle contract and simultaneously buy five 5,000 bushel May corn contracts if April feeder cattle trades .15 below a prior week’s low. Initially, the spread will be liquidated on a two-consecutive day close $500 above the multi-month rally high that precedes the entry (currently at -$7,137.50).