A.H.Alizadeh.N.K.Nomikos Transportation Research Part B 41 (2007)126-143 127 The price formation in the second-hand market for ships has also been examined to determine whether markets for ships are efficient and whether prices are formed rationally.For example,Kavussanos and Ali- zadeh (2002a),Hale and Vanags(1992)and Glen (1997),test the validity of the Efficient Market Hypothesis (EMH)in the formation of second-hand dry bulk prices.These studies argue that the failure of the EMH may either be attributed to the existence of time-varying risk premia,or reflect arbitrage opportunities in the mar- ket.The latter suggests that if prices for vessels are found to deviate consistently from their rational values, then trading strategies can be adapted to exploit excess profit making opportunities.For example,when ship prices are lower than their fundamental values,then buying and operating these vessels may be profitable since they are under-priced in comparison to their future profitability (i.e.the earnings from freight operations).On the other hand,when prices are higher than their corresponding rational values,then from a shipowner's point of view it may be more profitable to charter in vessels,rather than buying them,since they are overpriced in comparison to their expected future profitability. Despite numerous studies in the literature on ship price formation,on testing the validity of the EMH in shipping markets,and on the behaviour of ship prices and their volatilities,there has been little empirical evi- dence on whether sale and purchase decisions of merchant ships,based on fundamental and/or technical anal- ysis,can be profitable.For example,Adland(2000)and Adland and Koekebakker (2004)investigate the performance of technical trading rules and argue that if the market for ships is efficient,then trading strategies based on these rules should not produce wealth in excess of what can be gained through simple buy and hold strategies.Using both in-and out-of-sample tests,they report that,in general,trading rules do not yield excess returns that can compensate for transaction costs.Although their study seems to provide support for the EMH,given the nature of technical analysis there may be two points that could be raised.First,as they point out,their results might be dependent on the variables and set of rules used for constructing the tech- nical trading strategies.Second,the use of technical trading rules on their own,and not in conjunction with the underlying economic theory,may not be as effective in this market.This is because the historical pattern of the underlying series alone is not enough to extract information on the future behaviour of prices,since it is widely documented that ship prices follow random walk processes. Therefore,in this study we overcome these shortcomings by developing a theoretical economic framework which links prices and earnings,and then combining such a relationship with technical rules,to extract infor- mation from the market for investment and trading purposes.In other words,we do not rely only on the past price behaviour for trading strategies,but we combine technical trading rules with fundamental analysis by using the cointegration relationship between prices and earnings.In particular,we use the price-earnings ratio as an indicator for investment or divestment timing decisions in the dry bulk shipping sector.The motivation for this stems from the importance of economic indicators and,in particular,the price-earnings(P/E)ratio (or its inverse the earnings-price,E/P,ratio)in predicting asset returns in financial markets.For instance,P/E ratios of individual stocks or portfolios are regularly used to explain the returns in the stock market and a number of studies document the ability of P/E ratios to predict future returns of individual stocks or portfo- lios.For instance,Campbell and Shiller(1998)show that P/E ratios are negatively correlated with subsequent stock returns over a ten-year period.Other studies on the information content of P/E ratio in predicting stock returns include Fama and French (1992),Fuller et al.(1993),Jaffe et al.(1989),and Roll (1994). The spread between P/E ratios and interest rates is also used to forecast movements of broad stock market indices.For example,Lander et al.(1997)use various linear combinations of the P/E ratio and bond yields to predict returns on the S&P 500 index in a regression framework,while,Pesaran and Timmermann (1995) include both interest rates and P/E ratios as possible explanatory variables of stock market movements.In addition,a number of studies in financial economics literature examine the performance of various strategies that may be useful in timing the market.For example,Lander et al.(1997)test their models'ability to time the market,while Fuller and Kling(1990,1994)study regression-based market timing strategies using dividend yields,and highlight the inherent difficulties in finding market timing strategies. I Here by fundamental or rational value of assets we mean the discounted present value of the expected stream of income that the assets will generate over their lifetime. 2 Adland and Koekebakker(2004)use historical prices for VLCC and Aframax tankers,as well as capesize and panamax dry bulk carriers.The price formation in the second-hand market for ships has also been examined to determine whether markets for ships are efficient and whether prices are formed rationally. For example, Kavussanos and Ali￾zadeh (2002a), Hale and Vanags (1992) and Glen (1997), test the validity of the Efficient Market Hypothesis (EMH) in the formation of second-hand dry bulk prices. These studies argue that the failure of the EMH may either be attributed to the existence of time-varying risk premia, or reflect arbitrage opportunities in the mar￾ket. The latter suggests that if prices for vessels are found to deviate consistently from their rational values, then trading strategies can be adapted to exploit excess profit making opportunities.1 For example, when ship prices are lower than their fundamental values, then buying and operating these vessels may be profitable since they are under-priced in comparison to their future profitability (i.e. the earnings from freight operations). On the other hand, when prices are higher than their corresponding rational values, then from a shipowner’s point of view it may be more profitable to charter in vessels, rather than buying them, since they are overpriced in comparison to their expected future profitability. Despite numerous studies in the literature on ship price formation, on testing the validity of the EMH in shipping markets, and on the behaviour of ship prices and their volatilities, there has been little empirical evi￾dence on whether sale and purchase decisions of merchant ships, based on fundamental and/or technical anal￾ysis, can be profitable. For example, Adland (2000) and Adland and Koekebakker (2004) investigate the performance of technical trading rules and argue that if the market for ships is efficient, then trading strategies based on these rules should not produce wealth in excess of what can be gained through simple buy and hold strategies.2 Using both in- and out-of-sample tests, they report that, in general, trading rules do not yield excess returns that can compensate for transaction costs. Although their study seems to provide support for the EMH, given the nature of technical analysis there may be two points that could be raised. First, as they point out, their results might be dependent on the variables and set of rules used for constructing the tech￾nical trading strategies. Second, the use of technical trading rules on their own, and not in conjunction with the underlying economic theory, may not be as effective in this market. This is because the historical pattern of the underlying series alone is not enough to extract information on the future behaviour of prices, since it is widely documented that ship prices follow random walk processes. Therefore, in this study we overcome these shortcomings by developing a theoretical economic framework which links prices and earnings, and then combining such a relationship with technical rules, to extract infor￾mation from the market for investment and trading purposes. In other words, we do not rely only on the past price behaviour for trading strategies, but we combine technical trading rules with fundamental analysis by using the cointegration relationship between prices and earnings. In particular, we use the price–earnings ratio as an indicator for investment or divestment timing decisions in the dry bulk shipping sector. The motivation for this stems from the importance of economic indicators and, in particular, the price–earnings (P/E) ratio (or its inverse the earnings–price, E/P, ratio) in predicting asset returns in financial markets. For instance, P/E ratios of individual stocks or portfolios are regularly used to explain the returns in the stock market and a number of studies document the ability of P/E ratios to predict future returns of individual stocks or portfo￾lios. For instance, Campbell and Shiller (1998) show that P/E ratios are negatively correlated with subsequent stock returns over a ten-year period. Other studies on the information content of P/E ratio in predicting stock returns include Fama and French (1992), Fuller et al. (1993), Jaffe et al. (1989), and Roll (1994). The spread between P/E ratios and interest rates is also used to forecast movements of broad stock market indices. For example, Lander et al. (1997) use various linear combinations of the P/E ratio and bond yields to predict returns on the S&P 500 index in a regression framework, while, Pesaran and Timmermann (1995) include both interest rates and P/E ratios as possible explanatory variables of stock market movements. In addition, a number of studies in financial economics literature examine the performance of various strategies that may be useful in timing the market. For example, Lander et al. (1997) test their models’ ability to time the market, while Fuller and Kling (1990, 1994) study regression-based market timing strategies using dividend yields, and highlight the inherent difficulties in finding market timing strategies. 1 Here by fundamental or rational value of assets we mean the discounted present value of the expected stream of income that the assets will generate over their lifetime. 2 Adland and Koekebakker (2004) use historical prices for VLCC and Aframax tankers, as well as capesize and panamax dry bulk carriers. A.H. Alizadeh, N.K. Nomikos / Transportation Research Part B 41 (2007) 126–143 127