Is a rising Baltic Dry bullish for equities?

Schaeffer’s Investment Research recently put out this note on using the Baltic Dry Index (BDI) as an indicator for the S&P 500[ emphasis mine]:

The Baltic Dry Index (BDI) continues to rise. Many consider this an excellent sign for the world economy. The BDI is an index that measures the price of shipping dry bulk cargo, which includes coal, iron ore, and grain. Since the index is used to gauge the demand for major raw materials used in the early stages of production, it is regarded as a leading indicator for the economy…

The theory sounds great: a rise in the BDI signals a growing economy and, therefore, is a bullish sign for the market…History seems to back up this theory, as the SPX's returns following this signal outperform the index's typical returns. In the eight instances that the BDI rose above its 200-day moving average, there were positive returns seven times during the six months following the signal. The average six-month return for the SPX following such a move in the BDI is 7.24%. That's more than double the SPX's typical six-month return of 3.02%.

Incomplete analysis
While the analysis based on the recent action of the Baltic Dry Index and the S&P 500 sounds intriguing, the long term picture shows virtually no relationship between the BDI and the stock market.

The chart below shows the indexed returns of the two indices from 1985. The correlation of monthly changes between the BDI and S&P 500 from January 2007 was 0.33, which is relatively high to suggest some causal relationship. Looking longer term, the correlation of monthly changes was a miniscule 0.07, indicating little or no relationship between the two indices.



Vincent Fernando, who wrote the following note at Research Reloaded, agrees:

I have actually done a rather in-depth BDI correlation study in the past during my tenure as shipping analyst at Citi. One important thing to note about correlation is that you need to look at correlations for many different time periods because if you just calculate a single correlation then it will be highly dependent on your start and end dates…

I think its even best to step back from numbers or historical correlations and think about some very important differences between the nature of the BDI and the nature of a stock price for a company or market. The BDI measures the rate to ship something around the world, ie. the COST to ship something around the world. On the other hand, the stock of a company represents ownership of a productive asset, a company. (well, at least usually they are productive!) A company is seeking ways to be more efficient, grow the size of its business and generally increase its value.

The analysis from Schaeffer’s was at best incomplete and at worse sloppy and not well thought out. This is an issue that I have talked about over and over again: Good quants need to think about the assumptions in their models.

Beware of quant models bearing gifts.