The Fool's Game In The Baltic Dry Index

Did I mention that the Baltic Dry Index is soaring? I do hope that you are aware. :D

The Index rose another 2.398% or 61 points to close at 2605. I believe that this is the 11th week in a row that the index has risen.

With such an impressive surge, many as usual, are starting to make bold predictions. How to spot recovery in the world economy

• An overlooked barometer of economic activity is the Baltic Dry Index (BDI) which is a measure of the demand for shipping physical goods around the world, and hence it is a good gauge for world trade activity. The BDI is computed by The Baltic Exchange in London which grew out of the Virginia and Maryland coffee house in Threadneedle Street in 1744, where merchants and ship-owners would convey business.
  
  This index tends to be quite volatile because the supply of container ships is inelastic as it often takes a long-time for ships to be built to cope with a surge in demand. When there is a global slump this index will fall quite rapidly as experienced last year when this index dropped by a massive 96 per cent in 2008 from its peak value experienced during the previous May.
  
  The BDI per se is not a tradable index and is thus devoid of speculation, as well as political manipulation. It is thus a very objective measure of world economic activity when compared to other economic indicators. As at the close of business on May 7, it stood at 2194.00, up 21 per cent already this month and substantially up from its recent lows seen at the turn of this year of 773. It is slowly but surely beginning to literally swell up. It could well be that this is a true sign of economic recovery that President Obama has been remarking about. (See Bloomberg's charts for BDIY:IND Baltic Dry Index.)
  
  A potential way of following the returns on the BDI maybe to buy into an Exchange Traded Fund (ETF) that focuses on shipping companies. One such fund is the Russell Global Shipping Large Capital Fund (denominated in UK pounds) which is traded on the London stock exchange.
  
  Their index includes 29 securities from 12 countries which is rebalanced and reconstituted on an annual basis. However, this fund is currently heavily weighted towards shipping companies in Japan and USA, countries well down the league table of economic prosperity, which may mean this particular fund as it currently stands may take a long while to show signs of recovery. From the perspective of Australian investors there is also foreign exchange rate risk to consider as well in purchasing such ETF units. Without professional investment advice it is best advised to stay away from the stock market but nevertheless the BDI is showing positive signs of a revival.
  
  On the basis of the BDI recovering somewhat over the first quarter of 2009, it could well be that President Obama's assertion about the world economy turns out to be correct but the shipping lanes to recovery will remain choppy, hazardous but potentially rewarding. Ultimately, it could be our Australian merchant sea captains and not our captains of industry that spot green land ahead first.

Not all are convinced.

Here is an article published on Business Insider, Shipping Rates Are Lousy For Predicting The Economy (DRYS

• Because there is no way the BDI is a reliable leading indicator of much, if anything, let alone the stock market. If one wants to track commodities demand as a signal of the economy, just look at the actual nominal commodities demand. But before we go here, let's confront correlation studies such as the above and as frequently exist elsewhere.
  
  I have actually done a rather in-depth BDI correlation study in the past during my tenure as shipping analyst at Citi. One important thing to note about correlation is that you need to look at correlations for many different time periods because if you just calculate a single correlation then it will be highly dependent on your start and end dates. For example, in the Bespoke correlation above, they use a period where the US markets went up over 20+ years and when at the same time the BDI also went up. Surprise, surprise, the correlation is positive over this long period. But if you dig into the details, then one can find many examples where correlation was very negative, and to be fair they show this with their 2009 data. In addition to this, as I have found by doing correlation studies in the past on the BDI vs. shipping stocks in particular, the outcome for any sort of trading strategy based on correlation can differ greatly from your long term correlation. Correlations can reverse for long enough that you are wiped out if you follow some sort of period correlation trading strategy.
  
  Now to make things more clear, I think its even best to step back from numbers or historical correlations and think about some very important differences between the nature of the BDI and the nature of a stock price for a company or market. The BDI measures the rate to ship something around the world, ie. the COST to ship something around the world. On the other hand, the stock of a company represents ownership of a productive asset, a company. (well, at least usually they are productive!) A company is seeking ways to be more efficient, grow the size of its business and generally increase its value.
  
  What this means is that while shipping rates should track the cost to ship something around the world, which actually in the long term should be declining on a real basis due to human progress (and has been), a company (when managed properly), or collection of stocks, ie. a stock market, should actually be increasing in value over time on a real basis due to human progress. If we want to think about the value of all the companies in the world versus the cost to ship a ton of ore around the world, in the long term the value of global business will be increasing while the costs to float ore will be falling. For shipping costs to rise in the long term, humans would have to somehow become less and less efficient at transportation over time. Unlikely.
  
  Why do shipping rates seem to jump all over the place? Due to near term supply of ships versus demand for commodities. Its just a matter of bottleneck problems. If rates go up it can come from either of two things, not enough ships at the time or too much commodities demand at the time. In a situation where ship owners match demand, which over the long run they will, then rates won't sky rocket and will just track their costs plus some margin for their effort.
  
  Now in regards to the BDI as an economic indicator, and there are tons of similar views out there, I have just pasted an example below, where economist Susan Lee says the following..
  
  I suggest you watch an index that will tell you when the world economies are starting to perk up and when trade conditions are really starting to ease. It’s called the Baltic Dry Index. Essentially the Baltic Dry tracks the average daily price for shipping dry bulk like coal, iron ore, wheat and soybeans. There are three things that make it such a good leading indicator. One, the index looks at raw materials, so it captures activity at the very beginning of the production process. Two, it looks at ocean shipping, so it reveals what’s happening to international trade — the critical driver of global growth. And, three, the shipping business depends heavily on credit, so the Baltic Dry indicates whether credit is tight or loose. Back in 2005, when the world’s economies were just fine and credit was abundant, the Baltic Dry looked like a powerhouse. But it peaked in May of 2008. And it’s been heading almost straight down ever since — losing about 90 percent of its value.
  
  I don't mean to pick on the quote above alone, a lot of people are making the same argument, the quote above was just the most convenient at hand.
  But essentially one problem with using the BDI for economic forecasting is that the BDI could feasibly go up in an environment where commodities demand was shrinking, if the supply of ships was shrinking even faster. These would be negative economic factors. This is because the BDI's value is not solely driven from the demand side. To me, it makes far more sense to just look at nominal demand for commodities rather than the BDI since the BDI has the complicating factor of vessel supply growth one needs to consider. The other thing is that the BDI is a measure of spot rates for dry bulk commodities consumers who, generally, are in the near term forced to pay whatever it takes to get their raw materials shipped (A steel plant needs to keep operating despite some higher ore transportation cost). On the flipside, vessel owners are in a similar boat (no pun intended), and in the near term are generally forced to take whatever rate they can get to fill their ships. (A ship sitting around is just a cost, ie. fixed costs are high, thus using a ship at a loss is usually better than not using it at all)
  
  Because of these inelastic characteristics of supply and demand, and since the BDI is a measure of spot rates, the BDI is thus absurdly volatile. I can explain why via the following simplified example, which I used to use frequently at Citi.
  
  Imagine you have 10 loads of iron ore and 9 ships, and that every load of iron ore must be sent no matter what while every ship must be filled no matter what. Imagine the bidding war between those 10 iron ore consumers fighting over just 9 ships. Shipping cost would skyrocket since they all need to ship regardless of cost. Now imagine if a week later two more ships enter the market. Now imagine the bidding process. Suddenly the tables have completely changed. You have 11 ships, that all need to be filled no matter what, and only 10 loads of ore. Shipping rates would plunge, despite a period of just a week passing by. This is, in a simplified nutshell why the BDI is so volatile.
  
  Now, add to this the fact that predicting ship supply and commodities demand has a pretty high margin of error, at the same time remembering how sensitive the BDI is to small mismatches due to the inelastic nature of its underlying supply and demand, and you quickly realize that predicting the BDI is a fool's game and also that it is not a reliable forward indicator given that it is a spot rate index in a market where both sides are basically forced to close a deal due to high fixed costs. The BDI is measure of supply/demand mismatch at the moment, and can change drastically on a dime. Its little else beyond this. It hit its peak not when the global economy was in its healthiest state, but in early 2008 when things were already starting to come apart, but Chinese commodities demand growth still had some steam and just kept outstripping stagnant vessel supply growth. For a moment. And then it all collapsed. And BDI correlators got annihilated in popular stocks such as DryShips (DRYS). Thus, let's hope that we put to rest any talk of the BDI as a reliable leading indicator, even if in six months someone datamines some new, latest correlation.
  
  This post originally appeared at Reserach Reloaded.

Great stuff.

Some would even highlight the iron core issue. Everyone knows China is buying iron core. However, some would question if the iron core imported is nothing but plain inventory purchases.