Predictability of Bull and Bear Markets: A New Look at Forecasting Stock Market Regimes (and Returns) in the US

73 Pages Posted: 16 Apr 2020 Last revised: 22 Nov 2021

See all articles by Felix Haase

Felix Haase

University of Trier - Faculty of Economics

Matthias Neuenkirch

University of Trier - Faculty of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Multiple version iconThere are 2 versions of this paper

Date Written: November 19, 2021

Abstract

The empirical literature of stock market predictability mainly suffers from model uncertainty and parameter instability. To meet this challenge, we propose a novel approach that combines dimensionality reduction, regime-switching models, and forecast combination to predict the S&P 500. First, we aggregate the weekly information of 146 popular macroeconomic and financial variables using different principal component analysis techniques. Second, we estimate Markov-switching models with time-varying transition probabilities using the principal components as predictors. Third, we pool the models in forecast clusters to hedge against model risk and to evaluate the usefulness of different specifications. Our weekly forecasts respond to regime changes in a timely manner to participate in recoveries or to prevent losses. This is also reflected in an improvement of risk-adjusted performance measures as compared to several benchmarks. However, when considering stock market returns, our forecasts do not outperform common benchmarks. Nevertheless, they do add statistical and, in particular, economic value during recessions or in declining markets.

Keywords: Forecast Combination, Markov-Switching Models, Shrinkage Methods, Stock Market Regimes, Time-Varying Transition Probabilities

JEL Classification: C53, G11, G17

Suggested Citation

Haase, Felix and Neuenkirch, Matthias, Predictability of Bull and Bear Markets: A New Look at Forecasting Stock Market Regimes (and Returns) in the US (November 19, 2021). Available at SSRN: https://ssrn.com/abstract=3559215 or http://dx.doi.org/10.2139/ssrn.3559215

Felix Haase

University of Trier - Faculty of Economics ( email )

Germany

Matthias Neuenkirch (Contact Author)

University of Trier - Faculty of Economics ( email )

Universit├Ątsring 15
Trier, 54296
Germany
+49 - (0)651 - 201 - 2629 (Phone)

HOME PAGE: http://www.uni-trier.de/index.php?id=50130

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

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