Drozd: Reversal patterns signal a downturn in cattle prices

Markets can and often do change direction on a moment’s notice. Cattle prices were at a record high in early March 2012, but quickly turned down and dropped below the uptrending channel, thus ending the rally.

An uptrending channel develops during a period of rising prices and support is determined by a line drawn across the lows of the reactions. Once a trend begins in earnest, it has a very high tendency to persist. When rallies begin to fall short of the upper channel boundary, this could prove to be an important first indication that the current trend is running out of steam.

There’s the old adage, "The trend is your friend," so when prices break below the lower boundary (A), of the uptrending channel, this changes the trend and selling increases. As soon as sell-stops are triggered — prices plunge.

After a valid penetration of the channel’s lower boundary, prices will move with an initial thrust in that direction, but then will often turn back to approach the trendline (B), which invariably provides a selling opportunity.

We’ve all heard the expression, "What goes up, must come down." This is especially true in commodity markets. It is only a matter of time before a fully entrenched bull market, like live cattle, dies under its own weight.

The news is always bullish at the top, so tops are often elusive and difficult to predict. The outlook for higher prices attracts more willing buyers, who jump in at any price and this propel prices higher. Then, without any fundamental change — prices suddenly reverse back down on long liquidation.

I find that the best way to cut through all the positive, market-driving "news," often associated with the top of bull markets, is to have the discipline to rely on well-defined chart patterns.

Reversal patterns that appear on the daily, weekly and monthly charts are reliable tools for identifying a change in trend, especially when they emerge at the height of a bull market.

The first indication that cattle prices were about to turn down was when a two-day reversal provided a sell signal on March 2. This reversal pattern occurred on the April 2012 futures contract, as prices were challenging the contract high ($131.50).

Further verification of the impending downturn occurred when a two-week reversal materialized on the weekly nearby chart on March 9, which was followed by the development of a two-month reversal on the monthly nearby chart on March 30.

It is not all that uncommon to see a reversal pattern at the top of a rally on the daily charts, but when it is followed by reversal patterns on the weekly and monthly nearby charts, it adds all the more probability of an ensuing downturn.

I’ve illustrated the two-week reversal in the accompanying chart. On the first week, the market advances to new highs, and closes very strong at or near the high of the day.

During the following week, prices open unchanged to slightly higher, but fail to have follow through strength. Selling picks up, which stalls the advance and prices begin to erode. By week’s end, the market drops to around the preceding week’s low and closes at or near that level.

Market psychology: The two-week reversal is a snapshot of a 180-degree turn in sentiment. On the first week, the longs are comfortable and confident. The market’s performance provides encouragement and reinforces the expectation for greater profits.

The second week’s activity is psychologically damaging. It is a complete turnaround from the preceding week and shakes the confidence of those who are still long the market. The longs respond to weakening prices by exiting (selling) the market.

Keeping a watchful eye for reversal patterns in a bull market can provide insight and an opportunity to hedge prices before a market’s trend changes.

Send your questions or comments about this article and chart.

— David Drozd is president and senior market analyst for Winnipeg-based Ag-Chieve Corp. The opinions expressed are those of the writer and are solely intended to assist readers with a better understanding of technical analysis. Visit Ag-Chieve online for information about grain marketing advisory services, or call us toll-free at 1-888-274-3138 for a free consultation.

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