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Drozd: Livestock sector dodges bullet

The livestock sector breathed a sigh of relief when a “double top” formation appeared on the December 2008 Soybean Meal chart and accurately predicted the ensuing price decline.

Just as the news is always the most bullish at the “top,” it was no coincidence that soybean meal prices peaked on July 11, 2008, the same day that USDA released a crop report in which it reduced the U.S. corn and soybean yields.

A double top is a formation that appears with regularity in the futures markets. It is a signal of a reversal of a trend. Typically a double top begins with prices advancing into new high territory, followed by a market reaction whereby a portion of the advance is retraced. A second advance brings prices back up to the area of the previous high, which is then followed by a decline in prices that exceeds the previous reaction low.

Confirmation of the double top formation is complete when prices fall beneath the reaction low that occurred between the tops. The minimum objective is a price decline equal to the distance from the double top and the reaction low between them.

Referring to the chart shown here, the minimum objective was for meal to decline to $340.80 per ton.

Market psychology

The first top develops after a sustained price rise. It coincides with a growing willingness for the longs with large unrealized profits to cash in on their gains. The market runs out of steam as the supply of contracts for sale exceeds the demand, and prices begin to fall. This is caused by short sellers jumping in, as they are convinced the upward move has gone far enough.

The reactionary phase that follows the first top corresponds with contracts continuing to change hands, with old longs who are exiting the market with their profits, being replaced by new longs.

The market continues to decline until the price drop causes sellers to withdraw. From a longer-term perspective, the bull market is still intact, so when the price decline stops, buyers again step in and prices once more begin to move higher heading towards the second, or “double,” market top. The second top usually develops at approximately the level of the first.

The selling comes from the following speculators:

  1. the long-term position traders who rode out the reactionary phase and decide to become profit-takers;
  2. short-term traders who went long at the bottom of the reactionary phase and are now looking for a quick profit; and
  3. the “top pickers” who are waiting to sell the proverbial high of the move. The selling also occurs as long hedgers decide to unwind their long positions and short hedgers decide to sell to lock in a profit.

When prices penetrate the reaction low between the two tops, all recent buyers will have losses and will sooner or later be potential sellers. Once prices fail to mount any sustainable rally, hope begins to evaporate and long liquidation becomes a reality, which was the main reason for the decline in commodity prices from July 11 to August 11, 2008.

— 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 in the markets influencing agriculture. The information contained herein is deemed to be from sources that are reliable, but its accuracy cannot be guaranteed. Visit Ag-Chieve online for more educational tools and ideas about grain marketing.

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