Asset Allocation with Business Cycle Dependent Return Predictability
61 Pages Posted: 22 Feb 2015
Date Written: September 1, 2014
I compute economic gains for a power utility investor from taking business cycle dependent return predictability into account. Recent studies show that stock returns are only predictable in recessions, and bond returns are only predictable in expansions. I examine whether this finding can be exploited in real-time trading using modern forecasting models combined with business cycle dummies. Realized utilities are computed both for a one-period and a long-horizon investor. Given total certainty about the timing and duration of recessions, I find that there are significant economic gains to be made using these dummy switching models rather than their no switch versions. However, the gains largely disappear for even modest inaccuracy of techniques that identify business cycle turning points in real-time.
Keywords: Portfolio choice, business cycles, return predictability, bootstrap
JEL Classification: C53, G11
Suggested Citation: Suggested Citation