Early Stage Bear Market
The spread between sugar and corn may have ended a four-year bull market right when Q4 started last year. If so, historical precedent suggests that it could now be at the very start of a multi-year decline. That means there should be plenty of opportunity, both in terms of time and price, to take advantage of it. Spread traders would be wise to start paying attention to this one.
To even consider a potential spread trade, though, the IMC blog first likes to establish that the markets in question have historically exhibited a strong correlation. It can’t be just a short-term fluke.
In the past, there have been strange anomaly periods where markets with no fundamental relationship (like soybeans and silver, for example) were somehow highly-correlated for a few months. But that certainly doesn’t mean that it’s got the makings of a good spread trade candidate.
There have also been market crisis situations where markets that are normally unrelated all go to a correlation of one. Remember the crash of ’87 or the Great Financial Crisis of ’08? The temporary strong correlation of all markets was the product of a liquidity crisis and dissipated once the crisis has passed.
Therefore, we want to see decades of price history where a couple of markets have shown correlation.
Cousins, Not Twins
Go back the last thirty-five years on a weekly closing-basis, and you will see that the prices of sugar and corn are pretty correlated. This is likely due to the fact that both markets are used as derivatives to produce ethanol. Also, sugar and corn syrup are both used as sweeteners in food products.
Now, you’ll also notice that the correlation would strengthen and weaken. This ebb and flow of correlation is because the crops have some different uses, different main production areas, and several other fundamental differences that can impact one crop without directly impacting the other. So they may not look exactly like identical twins when you compare the charts, but they at least look related enough to be first cousins!
Despite the inconsistency in the correlation periods –heck, maybe even because of it- the spread between sugar and corn has offered some great trading opportunities. This often was the case after one market had outperformed the other for a prolonged period of time or when there was a temporary disconnect where one market was trending while the other was static or even trending in the opposite direction. Eventually, this divergence would end and a major price reversal in the spread would occur.
Historical Price Boundaries
A sugar futures contract controls 112,000 pounds of sugar and a corn futures contract controls 5,000 bushels of corn. So the blog converts the contracts to their market value before plotting a spread in order to simplify and clarify things.
About four months ago, the nearest-futures sugar contract was worth almost +$9,300 more a nearest-futures corn contract. Not only was this significant by being the highest premium in over six and a half years, but it was also only the fourth time in the last four decades that a sugar contract has ever reached a premium of +$9k or more over a corn contract. The prior three occurrences were followed my multi-year bear markets. Therefore, it would not be surprising if a major decline was on the horizon.
For how long? And, more importantly, how big?!
Consider the prior three bear markets that started above the +$9k mark:
The bear market that started from the October 1980 top lasted three years and nine months. The decline from top to bottom was approximately $44,300.
The bear market that started from the January 2006 top lasted two years and six months. The decline from top to bottom was approximately $35,300.
The bear market that started from the January 2010 top lasted two years and seven months. The decline from top to bottom was approximately $33,800.
The sugar/corn spread seems to act like a pendulum. After reaching an extreme on the high side, the bear markets that followed these three peaks crushed the spread to levels rarely seen on the downside. You can see that there have only been a few instances where the sugar contract value traded at a discount of -$12k or more to the value of a corn contract. Down at those levels, the spread always turned out to be a great buying opportunity again!
This price history certainly does not guarantee that the sugar/corn spread will drop tens of thousands of dollars over the next two or three years. But it does show us what occurred before, which tells us the potential and the probabilities of what could occur.
The Ratio Test
As always, we like to look at the ratio between the markets as well. This helps normalize the prices. It’s a filter that tells us if the market relationship really is truly at an extreme level by historical standards.
In early October the nearest-futures sugar/corn ratio peaked at 1.54:1. So the value of a sugar contract was worth 54% more than the value of a corn contract. Looking at the weekly price data of the last forty years, this was only the fifth bull market that pushed the ratio to 1.5:1 or higher. Therefore, the ratio confirms what the spread is telling us: Sugar is just way to expensive in comparison to corn.
On the other side of the coin, sugar is historically too cheap in comparison to corn when the ratio drops to 0.5:1 or lower. At that point, one sugar contract is worth only half as much as a corn contract. That hasn’t happened since the financial crisis.
The Price Action
Over the last two and a half years, the 150-day Moving Average has been a reliable trend indicator for the nearest-futures sugar/corn spread. When the spread closed below the 150-day MA at the end of November 2014 it continued its descent until August of 2015.
After a failed breakout above the 150-day MA in the first part of September 2015, the spread made a second attempt at the end of the month and was successful. This launched a runaway move that lasted for about a year.
Now, I do want to point out that two failed bearish trend change signals occurred in February and April of 2016. However, both signals were reversed within a couple of days.
Two months ago, the nearest-futures sugar/corn spread made a clean break below the 150-day MA. It has stayed below it the whole time since. Therefore, a trend follower would have to consider the spread to be in a bearish trend at the moment.
On the nearest-futures chart, the sugar/corn spread rallied off the December low and has been stuck in consolidation mode for the last month. The spread scraped against resistance at the 150-day MA. If it starts to roll over here, a second leg down could commence.
Looking at the May sugar/corn spread specifically, we can speed things up a bit and measure the trend according to the 50-day Moving Average. When this spread cracked the 50-day MA in October it signaled a bearish trend change. The spread then closed back above the 50-day MA again once the New Year began and turned bullish.
Interestingly, the uptrend did not continue after the January trend change signal. The May sugar/corn spread has been stuck in a sideways trading range. A break below the January low and close back under the 50-day MA would put the ball back in the bear’s court.
Let’s put this all in context. The fact that the nearest-futures spread peaked last year at levels that have previously led to major bear markets…
The fact that the sugar/corn ratio also reached historic extremes that have always been unsustainable…
The fact that the spread is still in a downtrend on the nearest-futures chart by virtue of the fact that it remains below the 150-day MA…
One would have to think that selling the May sugar/corn spread on a close below the 50-day MA would be a trade worth taking!
Place a hypothetical contingency order to sell one 112,000 lb. May sugar contract and simultaneously buy one 5,000 bushel May corn contract if the spread closes below the 50-day MA (currently around +$3,666). If filled, liquidate the position on a two-consecutive day close $500 above the 2017 high that precedes the entry (currently at +$4,923.90).