Warren Buffett’s “Desert-Island Indicator”

In This Issue:

Warren Buffett's "Desert-Island Indicator"
So what's the WBDII saying?
Doing the stock-crude-trade polka
Of bonds, stocks, commodities and the buck
What does it all mean for markets ahead?
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Last month, we examined the four major global stock indexes with specific focus on the Chinese Shanghai Composite Index (SSE) to see what they might tell us about where U.S. stocks were headed. The SSE has just come off a 20+% correction and is again moving higher. We also explored the relationship between the carry trade and stocks with specific focus on the New Zealand dollar/Japanese yen cross (NZD-JPY) which led the SPX at the 2007 peak and off the March 2009 lows.

Updated charts for these and other intermarket relationship we are watching may be found at



This month we begin our leading indicator discussion with a close look at an indicator that Warren Buffett would choose if he were on a desert island and only had access to one indicator to make his investment decisions.

The Buffett Island Indicator

The data that powers Warren Buffett's desert-island indicator or more appropriately, set of indicators, are produced by the Association of American Railroads (AAR) which publishes weekly data every Thursday morning. These indicators are useful because they show real demand for the raw materials and finished products for a broad spectrum of commodities and merchandise shipped by rail, which is still the most cost-effective way of shipping in the U.S.

For the month of September, the AAR reports that total U.S. freight rail traffic was down 14.2% from September 2008 (versus -16.4% in August from August 2008), intermodal (truck Trailers On Freight Cars) was down 14.6% (versus -16.7%) and Canadian rail traffic was down 13.9% (versus -20.5%) reflecting a recent resurgence in commodity demand. As the next chart shows, cyclical traffic (autos, steel, lumber, chemicals etc.) was down the most on a year-over-year basis at 44.6% in Q3-2009 versus Q3-08. We examined various data sets provided by the AAR and on a quarterly basis, all figures are down from the same quarter the year before.

The next chart of cyclical rail traffic versus the S&P500 (Figure 2) shows a weak historical relationship at best. But it is interesting to note the difference between the 2001-2 recession when cyclical traffic hardly suffered versus the current recession in which it fell off a cliff. There is little doubt that this time is different but it will take some time before we know if this is just a serious wound or something more long-lasting to our economy.


Figure 1 – Graph showing traffic (load numbers) of different types of rail traffic from baseline (coal and grain), and intermodal (truck trailers on flat car or TOFC) to cyclical (autos, steel, lumber and chemicals). The large drop in cyclical traffic is the lowest level on record dating back to 1989. Data – railfax.transmatch.com


Figure 2 – Comparison of the S&P500 Index versus railshare cyclical traffic (in Figure 1). The two are not highly correlated but the big drop in cyclical traffic is a concern longer-term.

So what's the WBDII saying now?

Few know exactly how Mr. Buffett uses the information to make investment decisions and those who know aren't talking. But it's a fairly safe bet that like the smart economists who use the rate of change, Warren is focused on the latest rates at which his key indicators are changing.

As we see from the next series of charts showing year-over-year (removes seasonal variations) change of 13-week rolling averages, total rail traffic bottomed in late June with a maximum drop y-o-y below minus 20% and traffic has improved since then. There are similar results for intermodal and cyclical traffic and although baseline traffic also hit a bottom, it appears to have rolled over again of late.


Figure 3 – Four weekly charts showing year-over-year changes to four different measures of rail traffic.

This is good news for stocks and the economy!

Doing the stock-crude-trade polka...

As those who have been following our analysis know, the Baltic Dry Index (BDI) is an indicator we follow and for good reason – it tracks shipping rates for dry goods transported by sea and since it is not traded on an exchange is less subject to speculation and manipulation. It is therefore a good indicator of real demand for goods and commodities used in manufacturing a wide variety of products around the world, as well as an economic bellwether.

After peaking June 3, 2009, the BDI had dropped nearly 50% by late September which was seen as a bearish omen for global recovery. Since then however, the BDI has resurged 20% which is somewhat bullish and indicates an increase in goods moving around the globe.

But the question for traders and investors is what does the BDI mean for markets since stocks lead the economy? As we see from Figure 3, the stock market and BDI peaked around the same time in late October 2007 while oil continued to surge higher. Notice the fact that from 2002 through 2007, oil and the SPX moved together and appeared to have positive correlation. That ended in October 2007 when oil continued to move up as the stock market dropped.

Initially the BDI dropped into late 2007 but then resurged to hit a new high in mid-2008 showing that global trade was ignoring the stock markets.

But then a very interesting thing happened. When the BDI peaked (June 6, 2008), oil peaked shortly thereafter (on July 3) and then like the BDI, oil prices dropped off a cliff. Energy traders appeared to be watching the BDI.


Figure 4 – Weekly chart comparing the S&P500, the cost of a barrel of light sweet crude oil and the Baltic Dry Index. Chart by Metastock.com

The BDI then bottomed December 5 and the price of oil (weekly) bottomed December 19, 2008. However, when the BDI last peaked in June 2009, oil did a stutter step and continued to move higher suggesting that oil demand was not being driven as much by shipping demand. It might have been speculation but could also been attributed to increasing passenger (automobile and airline) demand.

However, one fact is clear. Although the link between global trade and U.S. stock prices is weak, trade and oil prices are more highly correlated. A recovery in the BDI bodes well for increasing energy demand and an economic recovery (which has at least partially been already priced into stocks).

This brings us to our next chart...

Of bonds, stocks, commodities and the greenback

Traditional technical analysis textbooks (Pring or Murphy) will tell you that in a rally, bonds move first, followed by stocks then commodities. At market tops, they head down in the same order. This leads to the conclusion that the stock trader/investor has one warning at bottoms and tops while the commodity trader has two.

Why this order? Normally (if there is such a thing in markets these days), recessions are accompanied by falling rates as central banks attempt to get the economy going again through 'quantitative easing' and this causes bonds to start rising. This is followed by rising expectations for a recovery by stock investors who buy assuming earnings will rise (usually before they actually do). Then as industrial, commercial and retail product demand picks up, so does the need for resources (commodities).

In the next two charts, we see how this relationship has played out. In the early 1990s, bonds and stocks were moving up as commodities languished but by 1993, all were moving higher together. However, the traditional relationship was a little out of whack – commodities peaked first in 1996 (the tech bubble?), followed by bonds in 1998 then stocks followed in 2000.

Even before stocks peaked, commodities bottomed in 1999 and started heading higher, which turned out to be the beginning of a multi-year bull market. Around the same time that stocks peaked in 2000, 10-year Treasury bonds bottomed and began a bull market propelled by falling interest rates. Stocks didn't bottom until 2003, four years after commodities and three years after bonds. The traditional bonds, stocks, commodities relationship had changed.

Bonds then put in an interim peak in 2005 and commodities in 2006 before stocks peaked in 2007. Commodities and bonds bottomed (red and green up arrows in 2007) before stocks peaked (blue down arrow 2007), commodities (red down arrow 2008) then bonds peaked (green arrow 2009) before commodities quickly hit a bottom in 2009 around the same time as stocks and both then began to rally higher. Only this time, bonds peaked when stocks and commodities were bottoming. The whole business cycle (bonds, stocks, commodities) was completely turned on its head!


Figure 5 – Weekly chart of the S&P500 (stocks), 10-year Treasuries (bonds) and the CRB Index (commodities) showing bottoms and tops over the last 18-years. Chart by Metastock.com


Figure 6 – The same chart as the one above except with the US Dollar Index showing how the dollar has impacted stocks and bonds. From 1991 to 1998, all moved higher together. Two years after bonds peaked (1998), stocks did the same and as we see, the falling dollar (which fell as interest rates rose) helped propel bonds higher. Also notice that commodities (in Figure 5) peaked around the same time the dollar hit its most recent bottom in 2008. Chart by Metastock.com

It is clear that the traditional relationship between these three asset classes has changed. We can thank the credit crisis for that. Record low interest rates (read: extensive periods of central bank "quantitative easing") have helped, or as some argue, was the underlying cause of crisis.

So what's it all mean?

Both stocks and commodities fell in late 2007 and early 2008 but bonds just kept going higher. And now they too have peaked and have been falling since March. Fifty-year low interest rates have had a downright buoyant effect on bond prices (which move inversely to interest rates). But now given the value of the dollar, commodities must be considered cheaper in real terms than they've been in a long time (even with gold having hit a new high in nominal dollar terms).

For the most part, a weakening dollar is bullish for commodities (as well as bonds and stocks) as investors sell dollars to buy assets to 'hedge' value. But as we saw in the 1990s, a rising dollar was accompanied by rising stocks and bonds while commodities fell over the decade (probably due to foreigners purchasing US stocks in part due to the rising dollar).

It is interesting to note that at the beginning of the last recovery (2003) stocks, bonds and commodities were at or near their lows and all three rallied together (see Figure 5). This time around however, momentum indicates that commodity and stock investors are bullish and bond investors bearish about the economy. It is interesting to note that generally bond investors are considered "smarter" than stock investors since they tend to be right more often about market direction. Bonds also rally and peak first. (We shall see whether this is true now since there are a number of factors including current momentum pointing to higher short-term stock prices.)

In the 1990s, a rising dollar was bullish for stocks (international buyers) but in the 2003-7 recovery, a falling dollar was bullish (value hedge). If the dollar starts to rise in the near future, it will be bearish for U.S. multinationals with overseas income but bullish for domestic companies. But it will also make dollar assets (bonds, debt, and stocks) more attractive for foreigners. The obvious offset is that it will make our debt more expensive longer-term since a rising dollar reduces inflation. (In real terms inflation makes debt less expensive.) And our debt will also have to compete with stocks for investment dollars which means interest rates will have to rise (generally negative for stocks, bonds and commodities).

(Whew...sorry about this long-winded explanation, but there are a lot of moving parts here...)

As we have discussed in past issues, debt has become a much bigger force in our markets. Based on an estimate by Sprott Management, total U.S. debt (personal, corporate and government) plus unfunded liabilities (Medicare, Social Security etc) now totals $118 trillion, which means each U.S. household owes approximately $1 million! That, in our opinion, is the 800-pound gorilla in the room. Increasing resources will need to be diverted at all levels of the economy to make these debt payments – resources that will be taken away from growing revenues, earnings and the real economy.

Let's look at the basic demand-supply relationship. If printing presses did not exist, rising demand for dollars to pay our debt would drive up the greenback up as investors sold other currencies to buy Treasuries and other debt instruments. But since printing presses do exist, the supply-demand relationship is upset. There is some convincing evidence that US debt is being monetized by the Fed (printing dollars to buy Treasuries as other foreign central banks sell them). One simply has to look at the adjusted monetary base (Figure 5) to see this in action.

Although the politicians and bureaucrats are talking a strong dollar, they are acting to reduce the value of the dollar with rapidly rising deficits, debt levels and spending initiatives. (We just learned as I write this that the U.S. budget deficit for fiscal 2009 was a record $1.42 trillion, which was triple the 2008 deficit!

But no action reduces the value of a commodity than producing more of it for virtually nothing (paper dollars). And as the debt gets larger and interest from investors to buy debt instruments wanes (see Treasury International Capital flow chart), the need to print dollars will increase.

Here are the two possible scenarios we see going forward.

First, since every other central bank is racing to debase their nation's currency (to stimulate exports and their economies), there is a chance that the dollar could rise since it is measured by a basket of other currencies. A rising dollar at this point and given the current asset class relationships, would be bearish for stocks, commodities and bonds if it is accompanied by rising interest rates. We may get a technical dollar bounce since we are near lows but this will only last as long as our trading partners continue to debase their currencies faster than we do. However, this is the less likely scenario long-term given the size of our debt relative to our trading partners.

The more likely scenario includes a continued weak dollar policy due to the size of debt and rate at which it is rising compared to real economic growth (total debt has doubled in nominal dollar terms and grown 35% faster than GDP since 2000). But it all comes down the continued campaign to convince investors that Treasuries are a good investment by government and the Federal Reserve. We believe that fiscal realities will eventually come home to roost and investors will demand higher returns to buy Treasuries (= higher interest rates).

Until this happens, and that could be months ahead, we expect investors to continue to seek value in stocks (if earnings continue improving) and commodities for the foreseeable future. The weaker the dollar is, the greater will be the motivation to seek value in other asset classes.

A rising stock market from here is also technically supported by the carry trade (see http://tradesystemguru.com/content/blogcategory/54/88/#Update ) short-term at least.

From a long-term S&P500 earnings prospective, valuations aren't cheap, but they aren't expensive either based on this chart. For more charts and discussion on earnings go to http://tradesystemguru.com/content/blogcategory/54/88/#Stocks

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Questions or comments?

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Related stories and links:

Association of American Railroads http://www.aar.org/

What trillions being pumped into the global economy is doing to the real estate market. But will it last? http://ow.ly/uCZ0

Don't normally read the NYT but this simple theory on why our financial system nearly collapsed is worth a read... http://ow.ly/uCV4

At foreclosure auctions, broken dreams on sale http://ow.ly/uCt0

A comparative look at the new IMF GDP estimates... http://ow.ly/uClb

Where to find value in a liquidity drunk market: Bonds do it, stocks do it, even educated credit default swaps ... http://buzzup.com/fheq

This is interesting... Stock Whizzes Born Not Made... http://tinyurl.com/yjcozp5

So is this... Q3 foreclosures set a record... http://bit.ly/vPe3p

It's about time that large auto manufacturers took electric cars seriously http://ow.ly/uCoA

Check out our latest analysis and comments http://twitter.com/Matt__Blackman


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Posted 10-20-2009 2:31 PM by Matt Blackman