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When Following the Herd Pays Off
11/09/2012 8:00 am EST
Even if rains have somewhat alleviated the extreme summer drought in much of the Midwest, they’re not out of the woods yet, says Andy Waldock, of Commodity & Derivative Advisors.
The summer is over but drought fears continue to haunt the grain markets. The rain we never received this summer has turned into snow that we hope is coming. The corn and beans have long since been harvested but the US winter wheat crop is the next grain market to be left high and dry while European wheat is left to drown in its own wealth of precipitation.
The USDA Crop Progress Report showed 39% of the US winter wheat crop in good or excellent condition as of November 4. Sounds pretty good, right? The reality is that this is the lowest, “good to excellent” rating for this time of year in the 27 years that this report has been issued. The US Drought Monitor still shows drought across more than 62% of the nation. More importantly, the, “extreme drought” area still covers approximately 6% of the nation. This includes major growing areas like Nebraska and is expanding through the upper Midwest and Great Plains.
Meanwhile, across the pond, planting in France and England is well behind schedule with France’s plantings 24% behind last year’s pace. Further adding to the globally bullish tone is Russia’s recent reduction of this year’s harvest by half a million metric tons, which drops it to a nine-year low. These forces have reduced the global stocks to usage ratio, how much we have on hand relative to what we’ll need, to 25.4%, which is the lowest level seen since the 1970’s according to the USDA.
The tightness in the wheat market can be seen in its performance relative to corn and soybeans. Both corn and soybeans have pulled back considerably from the highs they made this summer. Corn is currently more than 12% off its August high and soybeans have pulled back by more than 14% from their September high. Wheat on the other hand is less than 6.5% off of the July high and has merely drifted lower following its peak.
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The technical name for the chart pattern that wheat has created since its high is called a, “bull flag.” The reason for the name is when looking at the chart it resembles a flag fluttering in the breeze at the top of a flagpole. The wheat market began a vicious rally in late June, climbing more than 50% in five weeks. This rally can clearly be viewed as the flagpole. The market’s meandering since the highs have been confined to a range of 11.5%. This range marks the boundaries for the flag. Finally, as the volatility has died down, the trading ranges have become smaller and smaller. This consolidation is illustrative as the flag forms the tip of its pennant.
The market’s quiet period of consolidation also leads to the eventual eruption once the trading boundaries are violated. The expected breakout will give clear direction to the market’s participants that it is no longer in a trading range and higher prices lie waiting ahead. The target of the bull flag formation can only be determined once the breakout occurs. The simple measurement is the addition of the consolidation distance between the breakout point and the lower boundary of the flag to the breakout point itself. This is a 1:1 trade since the expected risk, without managing the position, is equal to the profit at the trade’s target price.
The primary trend in the near future will certainly be higher. However, I’d like to add a note of caution to trading the wheat markets. Dennis Gartman always uses the line, “Wheat is a weed and will grow as such.” There have been several instances where a poor wheat crop has made a substantial recovery. These recuperative powers are best viewed quantitatively through the actions of commercial traders. These are the people whose livelihood depends on proper analysis of their market.
Mechanically speaking, one of the best trades is to wait for commercial traders to call a top in the wheat market. This can be seen in the Commodity Futures Trading Commission’s “Commitment of Traders” report. When the commercial traders start selling, we want to be with them. Trading a commercial sell signal has generated nearly $2.50 for every $1 risked while only being in the market for five days. Investors will profit from being long wheat. Traders will profit doubly as they ride the tight supplies higher and catch the fall from the peak, as well.
By Andy Waldock, Founder, Commodity & Derivative Advisors
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