What is going on with Baltic Dry Index?
Today, we are going to analyze a hot topic – Baltic Dry Index, which on 10 February reached a historic low of 290. It is believed to be an economic leading indicator, because it measures the cost of shipping the raw materials (iron ore, steel, cement, coal, grains etc.), which are essential for many industries in a manufacturing process. When the demand for the commodities moved by the dry bulk carriers is rising, the BDI will rise too. Due to this fact, this indicator provides a clear view into the global demand for commodities and raw materials, which can be a good forecast in which direction, the global economy will go. BDI changes are mainly caused by the demand site, because the supply of ships is approximately constant (the building of a new ship is a very long and expensive process).
However, many analysts think, that BDI is not very useful and generates a lot of noise, which is not correlated with the economy and the stock market too often. You can find a lot of articles, in which, the authors try to prove, that this indicator doesn’t work at all.
Let’s take a look on the analysis conducted by the Hard Asset Investor. He argues, that the BDI is a “roller coaster”, especially after 2003. The extreme swings, some as wide as 100% can be worrying, but for me is not a good argument at all. We are living in the age of proceeding globalization and development of new, big economies like China, India and Brazil. The world is tightly connected and sudden, strong changes are familiar to us. What’s more, the better why, to judge the usefulness of BDI, it to analyze its dynamics, not the “raw” level of the indicator. On the chart below, you can check, what the normalized BDI has told about S&P 500:
The ratio constructed this way, has a great chance to point out the major, turning points (2000, 2007). It’s not completely useless isn’t it? The author of this analysis has forgotten about two other, important things. Firstly, the supply of dry carriers don’t have an impact on BDI for most of a time, but each new ship (or a couple of them), can cause a quite, big slump. The second fact is that, BDI measures 23 shipping roads and due to this, it is a better indicator of the global economy, not a single market. One, big economy like for example Chinese, can push BDI down with a much lower import. It can hurt the countries like Australia, Chile, South Africa and South Korea (a significant part of export is going to China), but not necessarily everybody else.
The other articles like this one argues, that there is literally NONE cargo transport on the North Atlantic. It is a ridiculous statement based on the incorrect data interpretation and a simple lack of using a “zoom”. There are ships on the Atlantic and the world trade is safe.
If it’s safe, why the BDI is on the lowest level in history? We believe, that there are 2 main reasons for this:
- a temporary decline in Chinese import
- the ships supply growth; 5-10% year on year since 2010 according to this author
In conclusion, the slower economic growth in China is a problem, but it don’t automatically indicate the slowdown for other countries and stock markets.
Let’s come back to the UK and check, if the BDI is somehow correlated with our market. On the chart below, you can see a BDI and FTSE 250 with the bottoms marked by the vertical lines:
Out theory here is that, these sync points can indicate the start or the continuation of the bull market. The BDI has stopped to fall and is rising, which should mean, that the demand for shipping the commodities is going up. The bigger is the exchange of these assets, the better for the economy, companies and as a result, for the stock market and investors. Let’s check the paths created after each sync point, on the chart below:
We have here:
- one extremely negative path (10%)
- one negative path (10%)
- 2 positive paths (20%)
- 6 extremely positive paths (60%)
As we can see, out theory is correct. We have a great chance (80%) for a positive return one year after a bottom created by BDI. What’s more, most of the paths (60%), has generated a return higher than 20% in a year. It is a great result. The median return is +27%, which is about 8 pp. better result, than FTSE 250 (+19%) has generated in analogical period. Moreover, we can see, that 70% of all paths, don’t move about more than +/-10% during the first 3-4 months after the signal. It can be a strong argument, that the BDI is really an economic leading indicator.
The median path shows this dependence very clear:
The real growth has started after the 4 months, which gives an investor a planty of time to think through the meaning of the signal, overall macroeconomic situation and an investing strategy.
We have talked about boom signals, but what about the slumps? Can BDI predict the near bear market? Let’s take a look on the chart below, with marked peaks:
When the BDI hits the peak and starts to fall, we can expect, that the economy will go down or stop rising. The demand for the shipping of raw materials is going down, the companies will produce and sell less goods, their revenues will go down, same as the stock market. If it’s true? The chart below should enlighten us in this matter:
We have here:
- one extremely negative path (10%)
- 3 negative paths (40%)
- one neutral path (10%)
- one positive paths (10%)
- 4 extremely positive paths (40%)
The results for the sync points, which should indicate the slumps are much worse, than for bottoms. We have only 50% chance, that the signal will correctly predict a negative return one year after its appearance. The median return on the level of +3% is about 17 pp. worse outcome, than mentioned earlier +19% for FTSE 250. The overall tendency is weak but correct. As we have pointed out earlier, BDI is very effective in signalizing the major turning points (like the one in 2007).
Let’s take a look on the median path:
The shape is clearly horizontal and the maximal return isn’t higher than +7%. As we can see, the median path proves, that we cannot count on the big profits a year after the peak of BDI. Even, if we don’t experience strong declines, we will not earn too much.
It’s not wise to strike off the Baltic Dry Index. We have proved, that it can be a useful, leading indicator for the major, global market changes. It is very effective in pointing out the bull markets and much less reliable, if we are looking for a decline. To fully understand the meaning of BDI’s movements, you need to look on the underlying, global causes, not only a simple correlation between the level of it and a single market performance. Nowadays, the level of this indicator is the lowest in history and as we have shown, it have usually meant, that the growth would start within 3-4 months. The time will show, if the BDI will be reliable once again, but we can count on the decent returns in 2016.