How to Use the Baltic Dry Index as a Leading Indicator
07/21/2010 12:01 am EST
As the US stock market searches for direction in this ongoing correction, investors around the world are trying to read the tealeaves to determine what will happen next.
One esoteric and unusual indicator, the Baltic Dry Index (BDI), points to a new downtrend that started in June and could be forecasting economic weakness ahead.
Here’s how it works and what it might mean going forward.
The Baltic Dry Indicator started in London in approximately 1744 and is a measure of the daily cost of shipping raw materials by boat around the world. The index tracks dry bulk cargo vessels used for transporting commodities like iron ore, coal, and agricultural products. And what it really measures is shipping demand against the worldwide available capacity on dry bulk ships.
When this indicator rises, it indicates a rise in global demand for raw materials and commodities, and when it falls, it indicates lagging demand for these items. And demand for raw materials is a predictor for future economic activity because when producers want to build cars, roads, or buildings, they order more raw materials required for their products. These orders lead to increased shipping activity and the index rises.
As we all know, rising industrial activity usually points to economic growth and rising stock and commodity prices, so that’s why many economists and analysts track this index.
Many economists and market analysts will tell you that moves in this index precede moves in the stock market, both up and down, because global demand for raw materials is an early warning indicator of future economic production. For the last month, the Baltic Dry Index has started a steep decline and could portend a coming slowdown.
A rising Baltic Dry Index typically points to increased global economic activity, increased production, rising stock prices, rising commodity prices, rising interest rates, and rising value in commodity-based currencies like the New Zealand and Australian dollars. And a declining Baltic Dry Index indicates the opposite elements of global economic contraction. But the question on everyone’s mind is whether this is the start of a new bear market or just a correction.
While no one can say for sure, clearly numerous caution lights are blinking with recent economic news pointing to a slowing economy ahead.
Trading the BDI
For us as traders, the BDI can be a useful leading indicator for the major indexes as it tends to be very closely correlated to the S&P 500.
While there is no ETF that specifically tracks the BDI, one can get a close approximation with Dry Ships Inc. (DRYS), or the Claymore/Delta Global Shipping ETF (SEA), which was recently reintroduced and tracks the Claymore Global Shipping Index.
So with its recent ultra-bearish activity, the Baltic Dry Index appears to be flashing warning signs of a global economic slowdown ahead. The BDI is another valuable tool that could give you a peek into the future, and trading proxies for this index could be another valuable addition to your trading arsenal.By John Nyaradi of WallStreetSectorSelector.com