The Corn Correction

08/28/07 09:38:09 AM

by David Penn

The divergence after the divergence suggests a potential test of summer lows.

Security: CZ7
Position: N/A

Those who follow the cycles of commodity markets caution us that "August rallies in corn should be sold." The Commodity Trader's Almanac provides the warning and looks back on data starting in 1987 to reach this exact conclusion.

The culprit, according to author Scott Barrie, is a fear of late summer heat damaging the August corn crop. Barrie says these fears have turned out to be historically overblown, leading to the selling of any heat-based August rally.

What makes this cyclical maxim interesting in 2007 is that corn futures — basis December — appeared to have provided a bullish signal in July with the forming of a sizable positive divergence in the MACD histogram. This positive divergence was first signaled on July 25, confirmed on the close of the following session on July 26 at $3.33. Five days later, December corn was trading at $3.41 for a solid per contract gain of more than $400.

The rally that followed the positive divergence in December corn led to a significant moving average convergence/divergence (MACD) histogram peak. Although not unique in size — the MACD histogram peak of June was larger — these peaks often do anticipate near-term direction of prices, often after a brief countermove. I have written about this use of the MACD histogram a number of times for both Traders.com Advantage and Working-Money.com.

FIGURE 1: CORN, DECEMBER FUTURES, DAILY. A positive divergence in the MACD histogram in July leads to a bounce. A negative divergence in the MACD histogram in August looks to anticipate a correction that could result in a retest of the lows of August or of July. Note how the rally in August failed on its first encounter with resistance left over from the July highs.

Graphic provided by: Prophet Financial, Inc.

Here, the MACD histogram in early August tells us that the price highs accompanying the histogram peak will be exceeded before any significant correction. By "significant correction," I mean a correction that would produce, for example, new lows.

Sure enough, after a correction that tested the July lows briefly on an intraday basis, December corn futures rallied in late August and eventually took out the highs from earlier in the month.

However, in doing so, December corn carved out a negative divergence in the MACD histogram. Although not matched up a negative divergence in the stochastic, the reversal pattern in the MACD histogram — combined with the appearance of dark cloud cover on August 23 — should have served as a warning that upside momentum was waning and that a test of lower levels could arrive near term.

That test appears to be unfolding in the final week of August. The long lower shadow that developed during the last attempt to test the lows on August 16 should give pause to those who think moving December corn too much lower will be easy. While some softness over the next few days is likely, the positive divergence from July and the evidence of selling weakness in mid-August should keep losses in December corn moderate.

David Penn

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

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