Recently, disgruntled bears have begun pointing to the Baltic Dry Index’s (BDI) fall as a sign that there is a divergence that should lead the markets down. Once again, that translates a bad understanding of the correlations (or lack thereof) between the BDI and economic activity.

For starters, the BDI reflects the cost of shipping dry goods and generally especially raw materials across the globe.In recent months, its value has been hiked by China’s stockpiling of commodities and demand for shipping on short term.

The BDI is also very sensitive to marginal increases in demand and thus can be overreacting to temporary phenomenons such as Chinese stockpiling, if this demand exceeds the supply of ships then present.

This can be confirmed when you relate the BDI to the  very bleak picture of the US Industrial Production painted by this graph:

However, and that’s where a slip is often being made, the BDI reflects more the demand in shipping of commodities at a given moment than some real changes in economic activity. It does not predict or reflect the markets (hence often these reflections about the “illogicity” of the markets). Especially it does not reflect the activity of industries which have a supply of commodities nearby.

The correlation of the BDI to the stock markets is all but clear:

The Baltic Dry Index is currently riding an eleven day winning streak during which the index has gained 43%. Year to date, the index is now up 228%. Given that it is a measure of shipping rates, the increase in the Baltic Dry Index is regarded by many as an important indicator of an improving global economy. How this translates The Baltic Dry Index is currently riding an eleven day winning streak during which the index has gained 43%. Year to date, the index is now up 228%. Given that it is a measure of shipping rates, the increase in the Baltic Dry Index is regarded by many as an important indicator of an improving global economy. How this translates to the stock market, however, is unclear.

Illustrating the point here is an overlay of the S&P 500 and of the BDI:

And any correlation that may have existed imperfectly in the past has been totally turned around:

Over the long term (since 1985), the Baltic Dry Index and the S&P 500 have had a positive correlation of 0.5 (1 = perfect correlation, -1 = perfect inverse correlation). Like everything else recently, though, that relationship has been turned completely upside down. As shown in the chart below, the S&P 500 and the Baltic Dry Index have been moving in opposite directions for most of 2009. As one has risen, the other has declined, and when one falls, the other seems to rise. Looking at the correlation between the two shows that year to date, they have had a negative correlation of -0.4, which implies a significant inverse relationship between the two.

Because the BDI reflects the demand for shpping in cases like the Chinese example, it could go up when the Chinese are stockpiling and fall as a rock thereafter. In addition, in general, an excess supply of ships could very well drop the index as well, as illustrated by Vincent Fernando, a former analyst of shipping at Citigroup.

But essentially one problem with using the BDI for economic forecasting is that the BDI could feasibly go up in an environment where commodities demand was shrinking, if the supply of ships was shrinking even faster. These would be negative economic factors. This is because the BDI’s value is not solely driven from the demand side. To me, it makes far more sense to just look at nominal demand for commodities rather than the BDI since the BDI has the complicating factor of vessel supply growth one needs to consider. The other thing is that the BDI is a measure of spot rates for dry bulk commodities consumers who, generally, are in the near term forced to pay whatever it takes to get their raw materials shipped (A steel plant needs to keep operating despite some higher ore transportation cost). On the flipside, vessel owners are in a similar boat (no pun intended), and in the near term are generally forced to take whatever rate they can get to fill their ships. (A ship sitting around is just a cost, ie. fixed costs are high, thus using a ship at a loss is usually better than not using it at all)

This is excellently illustrated in the example Fernando shows to illustrate his point:

Because of these inelastic characteristics of supply and demand, and since the BDI is a measure of spot rates, the BDI is thus absurdly volatile. I can explain why via the following simplified example, which I used to use frequently at Citi.

Imagine you have 10 loads of iron ore and 9 ships, and that every load of iron ore must be sent no matter what while every ship must be filled no matter what. Imagine the bidding war between those 10 iron ore consumers fighting over just 9 ships. Shipping cost would skyrocket since they all need to ship regardless of cost. Now imagine if a week later two more ships enter the market. Now imagine the bidding process. Suddenly the tables have completely changed. You have 11 ships, that all need to be filled no matter what, and only 10 loads of ore. Shipping rates would plunge, despite a period of just a week passing by. This is, in a simplified nutshell why the BDI is so volatile.

Now, add to this the fact that predicting ship supply and commodities demand has a pretty high margin of error, at the same time remembering how sensitive the BDI is to small mismatches due to the inelastic nature of its underlying supply and demand, and you quickly realize that predicting the BDI is a fool’s game and also that it is not a reliable forward indicator given that it is a spot rate index in a market where both sides are basically forced to close a deal due to high fixed costs. The BDI is measure of supply/demand mismatch at the moment, and can change drastically on a dime. Its little else beyond this. It hit its peak not when the global economy was in its healthiest state, but in early 2008 when things were already starting to come apart, but Chinese commodities demand growth still had some steam and just kept outstripping stagnant vessel supply growth. For a moment. And then it all collapsed. And BDI correlators got annhilated in popular stocks such as DryShips (DRYS). Thus, let’s hope that we put to rest any talk of the BDI as a reliable leading indicator, even if in six months someone datamines some new, latest correlation.

Now, for the final demonstration of the argument. It just happens that Mr. Fernando’s point was illustrated by what happened in August. In fact, with the drop in demand from the Chinese for commodities, the dry bulk ships were in oversupply considering the low level of industrial production around.

Hence, what is driving down the BDI is merely the laws of supply and demand on that specific point. Sure, the stats indicate a recovery of Industrial Production in several countries, but this has mostly been the case of an inventory reduction across the board. While producers remain cautious, they will not stockpile on commodities for now, unlike the Chinese.

Case in point:

The Baltic Dry Index, a measure of shipping costs for commodities, fell for an eighth consecutive session in London as the supply of ships exceeded demand.

The index tracking transport costs on international trade routes fell 83 points, or 3 percent, to 2,689 points, according to the Baltic Exchange. That’s 23 percent lower than before the declines began. Last week’s 17 percent slide was the steepest drop since the end of October.

“Charterers out there seem to be well covered for their requirements, and as such we do not expect any turnaround in the short-term,” Rikard Vabo and Lars Erich Nilsen, analysts at Oslo-based Fearnley Fonds ASA, said in a note. “Congestion is also coming down quite significantly.”

What conclusion to draw from this story? Well, for one, beware of people who think they can draw simplistic correlations. If such was the case, then the traders all around the world would all be successful and rich. Markets play on hopes and fears. They don’t obligatorily relate to the present-day economy and they don’t care about the feelings of the people being trudged upon in an economic recession.

For the future, the demand of commodities will be important to see how the global economy rebounds (if it rebounds). But it is better to use other tools than the BDI to check that demand. Again, Q4 will the quarter of reckoning if the market has not figured it out before.