Regime Shifts and Stock Return Predictability
International Review of Economics and Finance, Vol. 56, Issue C, July 2018, pp. 138-160
50 Pages Posted: 4 Jun 2014 Last revised: 6 Aug 2019
Date Written: November 15, 2017
Identifying economic regimes is useful in a world of time-varying risk premia. We apply regime switching models to common factors proxying for the macroeconomic regime and show that the ensuing regime factor is relevant in forecasting the equity risk premium. Moreover, the relevance of this regime factor is preserved in the presence of fundamental variables and technical indicators which are known to predict equity risk premia. Based on multiple predictive regressions and pooled forecasts, the macroeconomic regime factor is deemed complementary relative to the fundamental and technical information sets. Finally, these forecasts exhibit significant out-of-sample predictability that ultimately translates into considerable utility gains in a mean-variance portfolio strategy.
Keywords: Return Predictability, Regime Switching, Predictive Regressions
JEL Classification: G11, G12, G17
Suggested Citation: Suggested Citation