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Using the Baltic Dry Index to make money in stocks

Using the Baltic Dry Index to make money in stocks

Traders go to big lengths trying to figure out the direction of the market. Turning into weathermen, farmers and astrologers, when looking for clues in the CPI, S&P the Dow and other indicators. But most of World trade happens at sea. Which makes the Baltic Dry Index an underestimated barometer for figuring out the stock market.

So I have to admit it. I don’t know that much about the Baltic Dry Index. I am a swingtrader who uses a combination of fundamental and technical analysis in my trading. And that is why I am writing this article. It is a selfish endeavour to learn more about this global macro indicator. And hopefully you can benefit from the research too. Because what I’ve found is that the BDI can be a good indicator for future stock prices. At least from time to time.

Importance of maritime trade

Ever since man started his voyage to venture out on the seas, trading has been his hallmark. The sea always had an allure for bold people seeking richess, fame and adventure. Be it vikings or conquistadors. Because being the top dog at sea has always been an important part of establishing influence and power.

It is not a coincidence that the United States took over as the World’s premiere superpower at the same time that the english navy lost its grip over the sea to the United States. The bottom line is that seatrade is important. And who controls it has a lot of power. Further, trade needs to happen to make the world go round. An old saying, possibly from Fredric Bastiat, is that ”when goods don’t cross borders soldiers will”.

The background of the index

The Baltic Dry index can trace its roots back to the British Empire. Specifically to the Virginia and Baltick coffeehouse, in London’s financial district, in the 1700s. The Baltic Dry index is the successor of the Baltic Freight Index and was started on november first, in 1999. It is a composite of three averages and considered an authority on seatrade around the world. It gets issued on a daily basis by the Baltic Exchange, which is an old trading exchange, based in London.

How it is compiled

Every day members of the Baltic Exchange call dry shippers around the world. And they ask them how much it costs to book raw materials and bulk materials for 22 different searoutes. They consider things like length of journey and the size and speed of the vessel used. These answers end up as an average in what is called the Baltic Dry Index, or BDI. To make sure that they are getting a correct view of world seatrade, they look at shipping costs for four different sizes of ships. These are called Capemax, Panamax, Handymax and Handysize, and are described in greater detail at the end of this post.

Leading indicator

The BDI is a leading indicator, according to its proponents. This is contrary to a lagging indicator like a moving average. Because it measures the supply and demand of bulk cargo and raw materials, like gold, oil and iron ore. And it is therefore thought to provide a glimpse of the future, since raw materials has to be bought before the products are made. Because producers need raw materials to start production and create new cars, airplanes and smartphones. As a result a rising BDI should be a sign of economic growth. Because when raw materials are in demand it means products are in demand too.

Difficult to manipulate

Inflation rates, job numbers and tax rates can all be manipulated to a certain extent. But since it takes around two years to build a Cargo ship, it means the BDI is very hard to manipulate. And it is devoid of speculation. Because Cargo ships gets booked for one thing, and one thing only. And that is to ship large quantities of material goods.

How a rising BDI leads to higher stock prices

An increase in the BDI should theoretically lead to higher stock prices. Because what causes increases in demand for raw materials is a strengthening Global economy. In short what happens is that producers sell more products, which leads to increased demand for raw materials and increased earnings, which in turn leads to higher stock prices. Because of the correlation between earnings and stock prices. Currencies, correlated with commodities, should start to increase when the BDI goes higher as well. For example the Canadian and the Australian Dollar.

Criticism

The criticism against the BDI, as an indicator, are the same arguments that its proponents put forth but turned around. Critics say that it can be manipulated contrary to what proponents say. They say ship supplies distorts it and that it is a bad indicator because of that. What they mean is that the supply of new ships can somestimes jump up very quickly. For example 20 ships can enter the market the same week, which could make the index drop like a rock. And at other times it can take very long before ships come to market. Which leads to large price differences and imbalances in the index. So if the index rises very fast it might be more because of few ships and less about a big increase in trade.

Best for the long term

The critics have a point. Because of its volatility the Baltic Dry Index might be more reliable as a very long term indicator. But even looking at the very long term data in this index has to be done with caution. Because the ships covered by the the original index has changed over time. And people have to figure out for themselves if they think this is a reliable indicator or not. Personally, I think it can be used as a supplement, to other indicators.

Another criticism is that today’s economy is far more driven by intangible goods. For example internet services. Which makes the BDI potentially less important. An example of that was in 2016, when it fell a lot. But without the underlying economy confirming a recession. Perhaps showing that a new paradigm, and a web based economy, has emerged.

Lost connection with the S&P500

It is worth noting that in the aftermath of the recession in 2008 the BDI did not recover. But the S&P did. And the BDI really hasn’t recovered until about now, when I write this in early 2020. And since 2008 these two indexes have lost their connection with each other more and more. Some think that the downfall between 2008 and 2015, in the BDI, happened because of an excess supply of ships. Created in the boom years leading up to the recession in 2008. And this is an interesting thought that is quite possible.

The critics have a point when they say that the S&P and the BDI can loose their correlation entirely going forward. Although I doubt that. Since the last twelve years have been very special in a historical context. And the ongoing trade wars in the pacific ocean could be a sign that we should not be too quick to forget about seatrade after all.

Gauging the Baltic through technical analysis

Let’s delve a little deeper into the correlation between the S&P500 and the BDI using technical analysis. The technicals show that there is a correlation between the Dow, the S&P and the Baltic Dry Index. But the correlation has gotten weaker in the aftermath of 2008. But it is now getting a little stronger again, as the charts show.

Baltic Dry Index weekly chart – Chart courtesy of Stockcharts.com
S&P500 weekly chart. As we can see the S&P has been doing well since 2009, while the BDI has only been rising since 2016. – Chart courtesy of Stockcharts.com

So where do we stand today? As the pictures show the correlation between the S&P500 and the BDI has gotten weaker but looks like it is getting stronger again. Perhaps because of the Trump tax cuts or some other change in the economy that has occurred in recent years. But what that means for the overall economy remains to be seen.

Conclusion

THE FOUR SHIP SIZES OF THE BALTIC DRY INDEX

CAPEMAX: These ships are 10 percent of the global fleet. They can carry more than 100 000 tons and are too big to pass through the Panama Canal

PANAMAX: 19 percent of the global fleet. These are ships that can take between 60 000 and 80 000 tons and barely fit through the Panama Canal

HANDYMAX: Also called Supramax. They are 37 percent of the global fleet. They can carry 45 000 to 59 000 tons of cargo

HANDYSIZE: 34 percent of the global fleet. These ships can take between 15 000 to 35 000 tons of cargo

Gauging economic activity with the Baltic Dry Index works to a certain extent. But it should always be taken with a grain of salt, like all other indicators, and should never be used all on its own. Moving averages, Dow Theory and momentum are all helpful tools in the right circumstances. But the BDI is not easily manipulated. And because of that it is an invaluable indicator.

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