The Number of Regimes Across Asset Returns: Identification and Economic Value
23 Pages Posted: 10 Sep 2011 Last revised: 3 Apr 2012
Date Written: September 9, 2011
A shared belief in the financial industry is that markets are driven by two types of regimes. Bull markets would be characterized by high returns and low volatility whereas bear markets would display low returns coupled with high volatility. Modeling the dynamics of different asset classes (stocks, bonds, commodities and currencies) with a Markov-Switching model and using a density-based test, we reject the hypothesis that two regimes are enough to capture asset returns' evolutions for many of the investigated assets. Once the accuracy of our test methodology has been assessed through Monte Carlo experiments, our empirical results point out that between two and five regimes are required to capture the features of each asset's distribution. Moreover, we show that only a part of the underlying number of regimes is explained by the distributional characteristics of the returns such as kurtosis. A thorough out-of-sample analysis provides additional evidence that there are more than just bulls and bears in financial markets. Finally, we highlight that taking into account the real number of regimes allows both improved portfolio returns and density forecasts.
Keywords: Bull and bear markets, Markov switching models, Number of regimes, Density based tests
JEL Classification: G11, G15, G22
Suggested Citation: Suggested Citation