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Regime shifts and stock return predictability

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<mark>Journal publication date</mark>31/07/2018
<mark>Journal</mark>International Review of Economics and Finance
Volume56
Number of pages23
Pages (from-to)138-160
Publication StatusPublished
Early online date3/11/17
<mark>Original language</mark>English

Abstract

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.