The Baltic Dry Index is an often neglected indicator of economic and investment performance.
The Baltic Dry is not part of an Estonian weather forecast, or an Eastern European vodka brand, but a valuable daily indicator of financial health and prosperity.
Google "Baltic Dry Index" and you get a few hundred thousand results. Google "p/e ratio" and you get over 20 million. Yet for anyone investing in the stock market, I would argue that having a sound knowledge of the Baltic Dry Index (BDI) is just as important as knowing about p/e ratios. I'm not suggesting, as some do, that it's a market prediction tool but I do think it is a practical economic indicator on a global scale.
What is the Baltic Dry Index?
The BDI measures the cost of shipping raw materials and commodities around the world. Basically, it's a number generated daily by the London based Baltic Exchange tracking worldwide international shipping prices of raw materials -- like iron ore, cement, coal, and even fertilisers -- on 22 different routes around the globe. The type and speed of the ship is also taken into consideration, as well as length of route.
The resulting index is incredibly sensitive to changes in supply and demand. This is easily explained by examining the simple facts of supply and demand in this industry.
It takes a few years to build a cargo ship. Any immediate increase in demand is therefore met not by an increase in supply of ships, but by an increase in price. Similarly, owners can't easily or quickly 'mothball' their ships so any decrease in demand leads to an immediate decrease in price.
Because the index is measuring the price of shipping raw materials (the input for finished goods some weeks and months in the future) it provides a leading indicator of economic activity.
This is quite simply seen by examining the performance of the index last year. It was over 11,500 in June but fell below 5,000 by September. By the end of October it had dropped below 1,000 before bottoming out at less than 700 in December. It's since recovered to about 3,000.
Why pay attention to it?
There are four reasons why you should pay more attention to the BDI than other indicators:
1. It is very sensitive to changes in economic outlook, unlike GDP figures for example.
2. It is not an estimate, like some payroll or employment figures.
3. It is based on fact and not subject to speculation as are stock, bond and commodity indices
4. It is not subject to revision, like many other economic statistics.
So, having established the BDI is rational, accurate and forward looking, how can we use it in our investing strategies? And what is it signalling now?
Well as I mentioned above, the BDI started plummeting in June, well before the market and the economy tanked. So can a fall in the BDI predict a fall in the stock market? Howard Simons, an economist and writer on the street.com has charted prices of the BDI against the S&P 500 and found that the Baltic benchmark is a good leading indicator for share prices.
I've taken a look at correlating the BDI with the stock market and I can't see it working as a short-term market prediction tool. However, based on my arguments above I do think it is a very good leading indicator for the global economy. And when the economy prospers, medium and long-term market returns tend to be decent.
Since the start of 2009, the BDI has been rising. Now that definitely indicates a recovery, even if it's from an extremely low base. I think I'll be watching this indicator over the next few months. If it continues to rise, or maintain its recent highs I'll be buying. If it starts on any kind of savage decline, I'll sit on the sidelines.
More from Tudor Davies:
