When Old Stand-Bys Fail

Yesterday’s Wall Street Journal carried a good article questioning the status of the Baltic Dry Index (BDI) as a barometer of global economic health. The theory goes that dry bulk shipping rates are a good indicator of demand for materials. As the article points out, shipping rates can also be affected by a supply glut of tankers, which means investors should be wary of putting too much stock into the BDI when evaluating the global economy.

This article reminded me of other popular indicators investors often follow without examining the underlying fundamentals. One example is the VIX index, Wall Street’s supposed fear gauge. Before the 2008 meltdown, a VIX reading above 30 signified heightened levels of fear and possible panic — the proverbial prelude to “blood in the streets.” Those who staked contrarian positions once the VIX raced past 30-40 must have been dumbstruck (and poorer) when it eventually topped 80 in 2008.

My caution against blind reliance on indicators extends to nearly all investment metrics. Even my beloved free cash flow (FCF = operating cash flow – maintenance capital expenditures) can be misleading. Ideally, high levels of free cash flow signify a strong company with a reliable business position but it is possible to goose FCF by starving capex, which would eventually undermine the company’s ability to continue generating high or even normalized earnings.

Hence my repetitive admonition that further research is always warranted when evaluating investment opportunities. Just because a metric has never failed you in the past does not mean it won’t fail in the future. Investors must always be on guard against our own ingrained assumptions and beliefs.

More on this topic (What's this?)
(ETN) High Anxiety
The Baltic Dry Index Is Not Reliable
Read more on Baltic Dry Index - BDI (BALDRY), Volatility Index (VIX) at Wikinvest

Leave a Reply

-->