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Market Advisor: Market Overreactions Create Pricing Opportunities

How can you recognize when futures markets have overreacted and there is a pricing opportunity?

By Frayne Olson, Crops Marketing Economist

NDSU Extension Service

Futures markets have a history of overreacting to uncertain market conditions and unexpected shocks. These overreactions can push prices too low when the news is negative or lift them too high when the news is positive. However, these price swings can create opportunities to either sell grain at above-average prices or purchase feed at below-average prices.

Two key elements are required for a market price overreaction. A high level of uncertainty about the future and fear are the two elements. No one can predict the future, so there always are different opinions about whether prices will turn higher or lower. However, unexpected events can create a high level of uncertainty about what changes will occur and how quickly adjustments will be made. Combine this with a fear of either missing a profit opportunity or sustaining losses from failing to adjust and the conditions are ripe for traders to overreact.

The June 10 World Agricultural Supply and Demand Estimate report confirmed that there still is considerable uncertainty surrounding 2009 crop supply and demand conditions. The projected ending stocks, or margin for error, for U.S. corn and soybeans are falling, while wheat remains relatively steady.

A drought in South America has reduced Argentina’s soybean production by 31 percent from the previous year. Brazil’s production has suffered a reduction of approximately 7 percent. These reductions have increased the demand for U.S soybeans in the international market, with China being a major buyer. The current estimated stocks-to-use ratio for old crop soybeans or the 2008 to 2009 marketing year is a very tight 3.6 percent. However, given the current weak economic conditions, how high can prices rise before international and domestic buyers begin to cut purchases? Will the expected increase in soybean plantings and summer weather conditions be sufficient to rebuild ending stocks to a more comfortable level?

Iowa and the western Corn Belt, which includes Nebraska, Minnesota and South Dakota, have had near ideal corn planting conditions. However, the eastern Corn Belt, which includes Illinois, Indiana and Ohio, has experienced delayed planting due to wet soil conditions. Will these planting delays have an impact on yields and total production? The recent economic turmoil has put severe strains on the livestock and ethanol sectors and raises questions about the feed and fuel demand for corn. Will the contraction in the livestock and ethanol sectors continue and will increasing livestock and oil prices create sustainable profit margins for these sectors?

A combination of drought and a late-spring freeze has damaged the Oklahoma and Texas winter wheat crop significantly. Projected 2009 Oklahoma winter wheat production is approximately half of the 2008 production. Texas production for 2009 is approximately two-thirds of the 2008 production. However, Kansas, the largest winter wheat producing state, is expected to have near normal production and there still are large world wheat stocks available. In addition, there is considerable uncertainty surrounding the spring wheat crop in the Northern Plains and the Canadian Prairie Provinces. How many acres of spring wheat and durum will be planted? Will the growing season weather hurt or help late-seeded wheat?

A high level of uncertainty, fear and price volatility are present in today’s crop markets. So how can you recognize when futures markets have overreacted and there is a pricing opportunity? In reality, this is part art and science. However, there are three general indicators that can help.

One set of indicators is the daily trading volume and open interest for the respective futures market. These values are reported daily by the commodity exchanges and often are included on futures price charts, which are available from a variety of Internet sites. Both of these statistics are general indicators of the strength of a price trend. The daily trading volume is the number of futures contracts that were exchanged during the trading session. Open interest is the number of futures contracts that remain open or are not offset at the end of the session. A high trading volume suggests that a large number of trades are fueling the price move. A large open interest signals that traders are confident that the price trend will continue.

A second indicator is the futures prices moving faster than cash prices during a price rally or drop. During a price rally, the futures markets may increase faster than the cash markets, so the basis increases. During a price drop, the futures markets may drop faster than the cash markets, so the basis decreases. A sudden change in the basis shows that buyers and sellers of cash grains are not responding as quickly to the new conditions. This also suggests that excess enthusiasm may be building in the futures markets.

A third indicator is when daily market commentaries report that there has been heavy fund or speculative buying or selling, but light commercial buying or selling. It is much easier for speculative traders to enter and exit the futures market than the cash market. As excitement grows concerning a strong price movement, more traders fear they may miss out on an opportunity to profit from the move or fear that their losses will mount, so they being panic selling.

If all three of these indicators are observed during a price trend, it is very likely that the futures market prices have moved beyond a level that can be justified by an analysis of the underlying supply-and-demand conditions. The futures markets have overreacted to the situation and a price correction is imminent.

Markets are far too volatile to be able to make specific pricing recommendations in this column. However, recognizing opportunities is an important first step in implementing a marketing strategy. The next step is to choose the appropriate marketing tool for the existing conditions. Choosing the correct marketing tools will be the topic of future Market Advisors.

NDSU Agriculture Communication

Source:Frayne Olson, (701) 231-7377,
Editor:Rich Mattern, (701) 231-6136,
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