Last week, I was gathering data to comment on the plunge in the Baltic Dry Index ((BALDRY)), which has now broken its September '09 support and is threatening further deterioration. The sinking ship (pun intended) has gone largely unnoticed, beyond a few mentions in the blogosphere. However, I've followed the decline, as I keep BALDRY on my ticker screen; after all, it's an alleged leading indicator of global economic health vis-a-vis trade supply/demand. By definition:
The index provides "an assessment of the price of moving the major raw materials by sea. Taking in 26 shipping routes measured on a timecharter and voyage basis, the index covers Handymax, Panamax, and Capesize" ... [and] indirectly measures global supply and demand for the commodities shipped aboard dry bulk carriers, such as building materials, coal, metallic ores, and grains ... the index is also seen as an efficient economic indicator of future economic growth and production.
As I watch my charts, I can't help but notice a surging S&P 500 (SPX) in the face of this BALDRY decline. Further, on a more narrow basis, I can't get over popular single names like surging Dry Ships (DRYS) and stagnating Diana Shipping (DSX). Both contribute to the broad BALDRY data, yet both are resisting the downward trend. Everything sank in coordination from May-July 2010. So, given these recent contradictions, I undertook a statistical analysis to ascertain how accurately BALDRY serves as an economic indicator. Further, I'd like to attribute a fundamental cause for the divergence between BALDRY and other measures, like SPX. Using the S&P Total Return Index* as my judge & jury, I find the statistical evidence insufficient to support BALDRY as an indicator in nominal terms. However, in controlling the SPX for US dollar fluctuations, I yield a more significant BALDRY:SPX relationship.
As a preface to my study, take a gander at BALDRY's ugly end to 2010:
(Click to enlarge) BALDRY index (2010)
Then, take a moment to compare an erratic BALDRY to SPX on an absolute basis since 1990:
I started my analysis here by comparing the two on a relative basis for all 9-month rolling periods since 1990:
The preceding relative chart shows volatile swings in the relationship, so I scatterplotted the relationship in an attempt to fit the data to some level of correlation:
The attributed R-squared here indicates that a mere 21% of the S&P's movement can be explained by the movement in BALDRY -- a weak relationship at best.
Yet, as a leading indicator, BALDRY's movements should take time to rear an effect in the real economy and perhaps SPX should even lag behind. Thus, to do justice to the comparison, I re-ran the regression analysis above using a 1-month, then a 2-month lag in SPX. The results were even less indicative of a significant relationship:
- BALDRY/SPX 1990-2010 (1-month lag): Correlation= 0.45, R-squared= 0.20
- BALDRY/SPX 1990-2010 (2-month lag): Correlation= 0.42, R-squared= 0.17
In one last attempt to draw a significant read out of my data set, I widdled down the sample to a 2002-2010 timeframe, which could represent a period of globalization overdrive (per Thomas Friedman). Again, nothing remotely significant resulted.
That evidence leaves me vindicated in my mistrust of BALDRY as a conclusive economic indicator. Nevertheless, I'm still unsettled by the current chasm in the index. A similar decline occurred back in July, at which time The Economist sought to apply some subjectivity to BALDRY "drying up:"
... the Baltic Dry seems to be signalling trouble ahead ... There are growing doubts, however, about what the Baltic Dry is actually signalling. The confusion is whether the index is saying more about the supply of ships than the demand for their cargoes. The index spiked dramatically in 2008 as China’s imports of commodities soared at a time when the supply of ships was constrained and port congestion added to demand for capacity. The financial crisis soon caused the index to fall back but not before this period of dramatic growth in demand from China had prompted a surge of orders for bulk carriers, especially the very largest ones that are used on the China trade routes.
These ships take around three years to come on-stream. Despite the cancellation of some orders the new ships are now flowing in: in the first half of this year the global fleet increased by 23% as new vessels came into service at the rate of 16 a month. There are now 23 such vessels arriving each month, adding to oversupply.
With even the S&P dropping in concert at that time, this explanation by The Economist seems to miss the forest through the trees. Yes, that falling BALDRY could be more indicative of the supply-side, yet in my mind, "oversupply" is the meme for our 21st Century economic situation -- whether China, America, Europe, housing or credit crises. So if BALDRY was flashing false signals due to an oversupply of vessels, then I don't read them as "false signals" at all, but rather the realization of excess [inefficient] capacity by upstream suppliers and transporters. (The summer slide in DRYS would support that notion.) With an uncharacteristic coincident alignment to BALDRY, SPX wasn't "signalling trouble ahead." Rather, SPX was correcting to account for the "on-streaming" of excess capacity. As it were, this occured during a federal stimulus doughnut-hole: after the expiration of the homebuyer tax credit, but before QE2. Therefore, no countercyclical federal stimulus was applied to prop SPX, and an uncharacteristic correlation ensued.
Returning to my impetus, today's plunging BALDRY is sharply contradicted by a rising SPX in an amplified affirmation of my statistical conclusion. What can explain the "amplified" divergence?
Yes, central bank intervention pops into my head. Global monetary policy was coordinated through 3q2010. But upon the Fed's QE2 announcement in November, the US decoupled from other sovereigns like Europe (who tried austerity) and China (who followed other emerging markets in tightening). Intuitively, Fed easing has supported SPX in a way that hasn't resonated entirely to BALDRY. SPX, after all, pertains to the domestic US, while BALDRY draws on various global inputs. BALDRY is based on US dollars, but non-US contributors to the index are subject to uneven economic environments that unevenly influence their local shipping demands -- perhaps now more than ever. To control for the "noise" of Fed easing, I filtered out the effect of the US Dollar Index (DXY) on SPX. Scatterplotting the data with this new dollar-indexed SPX compares it to BALDRY on an apples-to-apples basis. The resulting R-squared of 0.655 (Correlation = 0.81) echos a tighter fit than before:
Now, finally, what does this all mean? First, since 2002, 66% of the movements in the US dollar-indexed S&P 500 can be explained by movements in the Baltic Dry Index. That's far better significance, but it's still not satisfactory. Further, in controlling SPX for US dollar fluctuations, the recent bifurcation between the nominal SPX & BALDRY is reeled-in, however, the gap is still substantial:
Since QE2 announcement (11/3/2010)
- BALDRY: -34%
- SPX: Nominal +6.39%; Dollar indexed +1.85%
- Euro Stoxx 50: -0.06%
- MSCI EAFE +1.03%
- Shanghai -9.41%
I acknowledge that correlation doesn't imply causation, but QE2's arrival at the turnbuckle of SPX/BALDRY divergence clearly propped US asset values amidst crumbling underlying economic indicators (the Fed's gambit will end in hyperinflation if those underlying economic indicators don't mend beneath this SPX rally). That's in stark contrast to the SPX/BALDRY alignment in the Summer 2010, a period void of federal stimulus.
Similarly, the ECB initially balked at further easing, which left a hole in EU indices through the beginning of December. But ECB rescue efforts have returned Euro Stoxx to that November high in resistance to the BALDRY current. I'm an opponent of these Keynesian responses to economic woes, but with everything relatively peachy in US & EU Markets, somewhere, somebody must feel a shudder from the continued BALDRY plunge.
On the macro-level, China holds a large share of the decline, with its Shanghai index down 9.4% since the beginning of November, 14.9% off its peak.
If BALDRY is still suffering from an oversupply, then someone cut loose an outlook for stronger demand than has transpired. Frantic to choke-off inflation, China has certainly underwhelmed its forecasts. Yet, in the end, China, et al. won't realize a cumulative 34% drop in any macro datum, for the breakdown in BALDRY:SPX relationship is conveyed by the following:
Unlike stock and bond markets, the BDI "is totally devoid of speculative content," says Howard Simons, an economist and columnist at TheStreet.com. People don't book freighters unless they have cargo to move.
Whenever a 34% drop in BALDRY comes out in the wash, it's shrunk like your colored cottons, because central banks emerse their output gaps in hot stimulus. That's my takeaway from this study. BALDRY will always overreact, and since the Fed subscribes to Keynesianism, SPX will always underreact. The variables are other nations (ex-US) who have to contend with sustainable debt-loads. After fighting the 2008-09 crisis, these nations simply can't afford to apply countercyclical stimulus whenever BALDRY portends doom & gloom. With "hot money" all the rage & Emerging Markets all the trades, it will be interesting to watch where the BALDRY drop du jour is manifest.
*In fair disclosure, the S&P (like BALDRY) is another alleged "leading indicator"; plus, it's often an invalid proxy for economic conditions. While not the perfect response variable, SPX is still the neatest catchall to convey the "economic conditions" warranted by my study. From a trading perspective, I am (after all) trying to extrapolate a market trend in the wake of BALDRY price action.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.