Regime Shifts and Stock Return Predictability

Abstract

Identifying economic regimes ought to be useful in a world of time-varying risk premia. We apply regime switching models to common factors proxying for the macroeconomic regime and document the ensuing regime factors to be relevant in forecasting returns. Moreover, the relevance of these regime factors is preserved in the presence of fundamental variables known to predict equity risk premia. This finding continues to hold when additionally considering technical indicators. In particular, the predictive power of the three information sets — fundamental, technical and macroeconomic regime — is complementary and gives rise to significant out-of-sample predictability.

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