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Predicting stock returns: A regime-switching combination approach and economic links

Xiaoneng Zhu and Jie Zhu

Journal of Banking & Finance, 2013, vol. 37, issue 11, 4120-4133

Abstract: This paper introduces a regime-switching combination approach to predict excess stock returns. The approach explicitly incorporates model uncertainty, regime uncertainty, and parameter uncertainty. The empirical findings reveal that the regime-switching combination forecasts of excess returns deliver consistent out-of-sample forecasting gains relative to the historical average and the Rapach et al. (2010) combination forecasts. The findings also reveal that two regimes are related to the business cycle. Based on the business cycle explanation of regimes, excess returns are found to be more predictable during economic contractions than during expansions. Finally, return forecasts are related to the real economy, thus providing insights on the economic sources of return predictability.

Keywords: Stock returns; Predictability; Regime switching; Uncertainty; Time-varying predictability (search for similar items in EconPapers)
JEL-codes: C22 C53 G11 G12 (search for similar items in EconPapers)
Date: 2013
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Handle: RePEc:eee:jbfina:v:37:y:2013:i:11:p:4120-4133