Pork Bellies: From Poke To Broke

05/10/05 02:47:09 PM

by David Penn

The post-negative divergence decline was severe. And resistance at the 10-day EMA suggests more downside is possible.

Security: PBN5, LHM5
Position: N/A

A month ago in an article for Traders.com Advantage ("Pigs In A Poke," April 8, 2005), I warned about the possibility of an April correction in pork belly futures. At the time, I suggested that a sideways correction was as good a bet as a sharply negative correction, noting that "given the sharp correction in early March, traders should not be surprised if the month-long stochastic divergence leads to sideways prices in April, rather than dramatically lower ones."

Well, surprise, surprise ...

Figure 1: The month-long negative stochastic divergence in July pork bellies led to a dramatic collapse in prices over the course of April.

Graphic provided by: Prophet Financial, Inc.

By mid-April, July bellies had already fallen below their March lows (Figure 1). The decline was relentless, falling more than 12 cents with only one slightly higher intraday high after prices first closed below the 50-day exponential moving average (EMA). And for those unfamiliar with futures, a 12-cent decline at $400/cent is no minor matter.

Where does this leave bellies now in early May? Most immediately, note how July bellies have bounced in late April up into resistance at the 10-day EMA and then fell back. This suggests significant resistance at the 84.5-cent area and, potentially, another leg down should July bellies take out the nearby April lows.

Another potentially bearish sign for bellies is apparent in the chart of lean or "live" hogs. What sort of relationship exists between bellies and hogs? Here's Jake Bernstein in his book Seasonal Futures Spreads, talking about the pork bellies/"live" hogs spread:

Pork bellie/live hog spreads are highly speculative and very popular ... Essentially, in bull markets the price of pork bellies tends to rise faster than the price of live hogs. Consequently a typical bull-market bellie/hog spread would be long pork bellies and short live hogs. Conversely, in bear markets the price of pork bellies tends to fall faster than the price of live hogs, making a long live hog/short pork bellie spread desirable.

I should point out that the point of a spread is to minimize risk. So a trader who, in the later scenario, is long hogs and short bellies doesn't necessarily think that hogs will move significantly higher. As Bernstein points out, hogs lag bellies. So over the longer term, the long hog end of the spread would tend to lose money. The hope of the spread trader in this instance is that the short bellies end of the spread is making more money than the long hog end might be losing.

How is that relevant to whether pork bellies will continue to make lower lows? Consider the chart of lean hogs in Figure 2:

Figure 2: June hogs leaped up into an island gap in late December 2004. As traders pay more attention to the June contract in 2005, will hogs leap back down from the island gap?

Graphic provided by: Prophet Financial, Inc.

Clearly, the June hogs contract is showing toppy action since gapping up in late December 2004. It could even be argued that the island has taken the shape of a head and shoulders top. In any event, that contract just put in its lowest close in months--a close that is below both the 10- and 50-day EMAs.

It is quite possible that hogs are now displaying some of that lag relative to pork bellies. If so, then there are two possibilities. The first is that the pork products market is at the "sweet spot" of the long bellies/short hogs spread trade. This possibility, it should be mentioned, would put pork products in Bernstein's "typical bull market"--which, given the problems in pork bellies, would mean that pork bellies have all but bottomed.

The second possibility is that hogs are just beginning their decline. Even if bellies are closer to the end of their bear market than the beginning, there is still more downside work to be done in bellies.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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