Looking for Turning Points
September 11, 2012 Leave a comment
Buy low, sell high is the asset play mantra, but timing is crucial. Can we spot when to buy, and sell?
In 2005 Amir Alizadeh, Nikos Nomikos and Stefan Van Dellen of Cass Business School in London produced a paper “Investment Timing and Trading Strategies in the Sale and Purchase Market for Ships” examining a method for timing sale and purchase activity. The model is based on the Price / Earnings ratio (P/E), familiar to investors in the stock markets.
Investors in shipping are looking for two sets of gains, the capital gain from ship price appreciation (the buy low, sell high) and gains from trading the vessel (earnings). The two gains are linked, as it is the increase in earnings that drives the expectation the price will rise. This can be seen in the chart of the long term relationship between price and earnings. It illustrates the lead out (to use cycling terminology – I am still on an Olympics buzz) of earnings, and then the “sprint” in prices. The researchers found that just before any significant market recovery, the spread between earnings and prices tends to narrow. This is can be seen clearly in the run up to the boom.
The model uses this theoretical relationship and gathers information on the difference between the long term mean P/E ratio and current P/E ratio. Slow and fast Moving Averages (MA) are used to filter the information and it is the spread between the differences between the MAs and the long term mean P/E ratio that throws up the buy or sell signal. A positive difference indicates the start of a price appreciation era, and a negative difference indicates the start of an era when the price will fall. The researchers tested the theory against a buy and hold strategy (it fared better) and for statistical anomalies. They also ran Monte Carlo simulations on the trading rule and found that overall it fared better than a buy and hold strategy.
The original paper was published in 2005, and I wanted to see if the P/E ratio theory could tell us something about market today. The original paper measures the P/E ratio for several sizes of bulk carrier, using the five-year old price, and the one year time charter rate as a proxy for earnings. In the model the one-year timecharter rate is used instead of spot earnings because this contains information about future expectations. I have stripped down the model to just the Capesize vessel, and extend it to the end of August 2012 (the data in the original paper ended in 2004), to see what the indicators are showing today.
The table below shows my application of the P/E ratio trading rule theory to five-year old Capesize prices. Any errors and omissions are my fault, not that of the original researchers, Cass Business School or anyone else. I did not test it against a buy and hold analysis, nor have I done a Monte Carlo analysis of the rule. This is not investment advice and you should do your own research and due diligence. The table is for illustration and entertainment purposes only. What the table illustrates are 11 Buy / Sell phases indicated by my version of the P/E Ration theory.
Two of the Buy / Sell phases would have produced a negative result. In the first, (May 1994 to November 1995), the timecharter rate steadily rose during the period, so there may have been a positive operating result to balance the capital loss. The second loss period (September 2011 to March 2012) had declines in operational gains and capital gains. In both cases the Sell indicator was triggered around six months too late. But the investor would not have sold then as the sale price was below the initial purchase price. Most likely the sale in these eras would have occurred on the respective peaks. In five of the Buy / Sell phases, the timecharter rate declined during the hold period. Also the indicators seem to miss the peak price realizable during the hold period, so the gains were not optimized. Altering the fast and slow moving averages or introducing other filters (as in the original study) would probably give a clearer picture.
The researchers in 2005 found the trading rule correctly identified the buy signal when in the 2003-2004 market when earnings increased sharply compared to ship prices. This comes across in phase six. Later, in phase eight, trading on the buy and sell figures would have produced the biggest capital gains of $79.5m, and dragged the investor out of what was to become an illiquid sale and purchase market. But most of the time the capital gains were small, or another way of looking at it, is that the losses were controlled.
The latest buy indicator was triggered in August this year. Overall Capesize rates and prices are similar to those of the 1990s, and I expect that when the Sell indicator is triggered, the capital gain will be relatively small, too. I will let you know.
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