Investors are continuously searching for a leading indicator that would give good entry and exit signals and prevent investors from losing money. Today, it would be foolish for someone to claim that a reliable indicator exists. Even the famous Merton and Scholes, after the collapse of LTCM, agreed that there is no such crystal ball, especially given the current market. However, investors can rely on few financial indicators to measure the state of the global economy the same way lights at the cross road gives you the signal to stop or keep on driving.
Two indices followed by most investors are the London Inter Bank Offered Rate (LIBOR) and the Baltic Dry Index (BDY). This article will take a look at the Baltic Dry Index since it is a bit more straightforward and easily digestible.
What is the Baltic Dry Index and what does it measure?
The Baltic Dry Index is a daily average of prices to ship raw materials using Dry Bulk Carrier. It represents the cost paid by an end customer to have a shipping company transport raw materials across seas on the Baltic Exchange, the global marketplace for brokering shipping contracts. The Baltic Exchange is similar to the Chicago Mercantile Exchange in that it is a medium for buyers and sellers of contracts and forward agreements (futures) for delivery of dry bulk cargo. The Baltic is owned and operated by the member buyers and sellers. It is an index free of speculation as only members of the exchange can trade the index.
What does it really mean and how can investors take advantage of the shifts in the Index?
The level of the index represents the price industrial companies are willing to pay to ship raw materials across the world. It is, therefore, a good indicator of the supply and demand for raw material across the world. The higher the index the stronger the demand for iron ore, coal or cement. And inversely, the lower the level, the weaker the world demand for raw materials. Since raw materials demand is directly linked to economic growth around the world, the BDY is often used as a leading economic indicator by economists. However, it is an imperfect indicator as prices are driven by few others forces than just the supply and demand of raw materials:
- Fleet Supply: the higher the number of ships the lower the premium paid by buyers.
- Weather: during the winter in the Northern hemisphere, price tends to be higher due to increase in demand for coal or other commodities used in the heating process.
- Bunker Price: bunker oil represents about 1/4 of the vessel operating cost. So when oil prices increase around the world like in 2007 and 2008, it tends to distort the BDY from reality.
- Port Congestion: ports’ infrastructures around the world are obsolete and need to be improved. As a result ships are stuck in traffic at the entrance of ports, which tends to put upward pressure on price during a period of strong global economic growth like in 2007 and 2008.
How can investors play a rebound of the Index like the one observed since December 2008 (the index increased from 600 to 2000)?
An increase in the BDY expresses a stronger demand for commodities, and therefore one could argue that it would be a good time to buy stocks in the automobile or construction sectors. However, an increase in the BDY typically indicates that there is an expectation for an increase in demand for finish goods 6 to 12 months from now. Therefore, it might be best to hold off on buying automobile/construction stocks until that 6-12 month timeframe, and instead invest in the shipping companies as they are the ones impacted directly by the increase in the BDY in the short term.
In the chart below, you can see the correlation between the share price of the three biggest Japanese shipping companies and the BDY since 2000. Japan has historically always been a leader in maritime transport, which would suggest companies like Mitsui OSK Line (OTCPK:MITSY) or Kawasaki Kisen (OTCPK:KWHIY) when playing a rebound in the BDY. However, you can invest in other companies like: China Ocean Shipping Company (OTCPK:CICOF), China Shipping, Frontline (NYSE:FRO) or BW Gas.
The recent rebound in the BDY has been as rapid and violent as the crash of the index from 12000 to 600 in 2008. The reason for the sharp increase in the BDY since December seems to be caused by the need for Chinese manufacturers to rebuild their inventories to more sustainable levels. It is doubtful that the index will continue to increase given the global recession, and it is probably too late now to invest in shipping companiesm as most of them already had a 40% rebound since December. However, it is advisable to keep an eye on the BDY over the next few weeks to have an idea on the direction the global economy is taking.
Disclosure: Emerginvest is an international finance portal, providing analysis and data on 120+ world markets to help individuals find investments from around the world. The author, Olivier Levant, does not hold positions in the equities listed in this article.