Not all bull and bear markets are alike: insights from a five-state hidden semi-Markov model

Valeriy Zakamulin ()
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Valeriy Zakamulin: University of Agder

Risk Management, 2023, vol. 25, issue 1, No 5, 25 pages

Abstract: Abstract This paper employs the hidden semi-Markov model and a novel model selection procedure to determine different regimes in the US stock market. The empirical results suggest that the US stock market is switching between five states that can be classified into three bull states and two bear states. The three bull states are categorized as a low-volatility bull market, a high-volatility bull market, and a stock market bubble. One of the bear states represents a regular bear market, while the other corresponds to either a stock market crash or a market correction. The paper demonstrates that the five-state model is consistent with a number of stylized facts and provides many valuable insights into the regime-switching dynamics of the US stock market and the risk-reward pattern of each regime. Besides, the paper demonstrates that the five-state model enables investors to make better asset allocation decisions. Specifically, in out-of-sample tests, the asset allocation strategy based on the five-state model achieves higher performance with lower risk than the strategy based on the two-state model and the buy-and-hold benchmark.

Keywords: Semi-Markov models; Stock market regimes; Bull and bear markets; US stock market; Optimal asset allocation (search for similar items in EconPapers)
JEL-codes: C22 G10 G11 (search for similar items in EconPapers)
Date: 2023
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DOI: 10.1057/s41283-022-00112-y

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