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Baltic Dry Index

Posted By Doug Tucker On November 6, 2007 @ 5:08 pm In | Comments Disabled

The Baltic Dry Index, or BDI, is an index of twenty-two key dry bulk shipping rates and is compiled daily in London. This index provides an assessment of the price of moving raw materials such as iron ore, grains, coal, and cement by sea. This index does not include wet goods such as crude oil.

Since this index is not a tradable contract, it does not have a direct speculative component. Although contracts that do contain a speculative component can influence the cost of shipping. One component that has a speculative component, by as much as 30% as this is being written (October 2007), is crude oil. Another is the U.S. Dollar. Since the index is being quoted in dollars, the sharp fall in the dollar is partly responsible for the recent near vertical rise in the index.

So why would an investor or trader care about how much it costs to ship dry goods by sea?

Transportation by sea can be a good barometer of the volume of world trade. This index can be a good economic indicator for future growth and production, since the raw goods being shipped are precursors to production. Also, since the number of ships available is relatively fixed, the price of shipping can go up or down based on supply and demand. If world growth slows, the cost of shipping raw goods will decrease. If world growth accelerates, the cost of shipping raw goods will likely increase.

Today a large portion of the demand for raw goods comes from China. The growth cycle in China influences the profits of many companies around the world. Having an index that can give a clue to when the trend of the demand for raw goods is increasing or decreasing can give important clues to possible changes in broader economic activity.

A century ago the Dow Theory was gaining in popularity, and it is still in use. However, it is much less effective in the new global environment. Part of the Dow Theory requires that a new high in the Dow Jones Industrial Average is to also be confirmed by a new high in the Dow Jones Transportation Average. A failure of both averages to confirm a new high, at least within a reasonable time, would usually imply a potential reversal of trend, to be confirmed by the price action itself. On the other hand, if both averages confirm the new high, the trend is assumed to be intact, and prices can be expected to move higher. The same theory in reverse can be applied to confirmation or non-confirmations of lows, therefore buy signals could be derived from one index making a new low while not confirmed by the other. The basis of this theory is that if goods are manufactured, or raw materials are mined, it is important for the companies that move these goods around the county to also be increasing in value. Using an average of stock prices doesn’t directly measure the cost of transporting these goods, as it does by actually measuring the cost of shipping, but if the transportation companies are making more money, one might infer that there is more transporting activity, and therefore more economic activity in general.

The chart above shows the Dow Industrials in the upper graph and the Dow Transports in the lower graph. You can see the last high in the Industrials was not confirmed by the Transports. That is the new high only occurred in the Industrials in the upper graph. But if you take the BDI, which is the blue line, into account, the high in the Industrials is confirmed.

Now that the economy has become more global, with China and other emerging markets becoming a more important factor in the world economy, a different type of transportation index is required. The Dow Jones Transportation Average is composed of stocks of companies beyond just the components that transport raw and finished goods. For example, airlines moving people and small packages are also included. While that may indicate current economic activity, it does little to forecast future economic growth in the way raw goods can. Also, much of the activity is domestic, so it does not represent the global picture. While there are some companies represented that deal with global delivery of goods in general, it is quite diluted, and not an accurate measure of the shipment of raw goods. Measuring the actual cost of transporting the raw goods, rather than the value of the stocks of transportation companies, can be a more direct indication of the trend of economic activity. If a transportation average fails to confirm an industrial average at a new high or low, it might be a good idea to also check to see if the BDI is making a more meaningful confirmation.

The above chart shows the BDI, again as a blue line, overlaid on the Xinhua China 25 ETF, or FXI. There is a very high correlation between the two.

The above chart shows the same two price series, but as a weekly chart with the FXI going back to late 2004.

The above chart shows the BDI again as a blue line, but this time over the Dow World Index. You can see some leading characteristics in areas where the BDI index tends to accelerate ahead of the Dow World Index. There are a few instances where the BDI falls back and corrections in the World Index follow, although corrections on this chart are very shallow so far.

Above is a similar chart, but this time with the BDI over the World Basic Materials Index. Since raw goods are the main items being transported, it seems logical that there would be a correlation between the index of basic materials and the cost of shipping them. These two indexes show very high correlation in direction as well as magnitude.

Above is the BDI over the continuous NY Copper Futures chart. Here the correlation is a little less obvious. The copper market had a tremendous rally in anticipation of the demand from China. The BDI was a bit behind the acceleration phase of the copper market. As metals prices rise, producers can usually increase production with the result of halting the price escalation. However, demand for copper stayed high at the new higher price. Even rising fuel costs didn’t slow down the demand.

The above chart with the continuous Light Sweet Crude Oil contract shows much less correlation, as one would expect, since this index is related to shipping dry goods, and crude is obviously not dry.

As has been indicated elsewhere in this article, much of the rise in the BDI is a result of the price being quoted in US Dollars, which have been falling. Therefore there is a strong correlation between the Euro Currency and the BDI. There would be an even better correlation between the BDI and the US Dollar Index, but inverse.

As with the Euro, there is a correlation with the price of gold, but it is not a close as it is to the inverse relationship with the dollar.

The Ten Year Treasury-Notes (price, not yield) display a fairly close relationship for much of the above chart. One would logically think that higher shipping costs would be inflationary, which would cause yields to rise, therefore Treasury Note prices would fall. But that does not seem to be the case, as can be seen in much of the above chart.

The BDI isn’t always a leading indicator. At times it is coincident, and at times it can lag. It has flaws, as does any index. It can have short term swings that can be more influenced by dollar and oil gyrations. But using the BDI in a longer-term context to view the trend of the cost of shipping can give important clues to the trend in world economic growth or contraction. It can be an important piece of the puzzle to determine longer-term trends in the world economies.

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