Does non-linearity help us understand, model and forecast UK stock and bond returns: evidence from the BEYR

David G. McMillan

International Review of Applied Economics, 2012, vol. 26, issue 1, 125-143

Abstract: The usefulness of non-linear models to provide accurate estimates and forecasts remains an open empirical debate. This paper examines the nature of the estimated relationships and forecasting power of smooth-transition models for UK stock and bond returns using a range of financial and macroeconomic variables as predictors. Notably, evidence of non-linearity is stronger when the bond-equity yield ratio is used as the transition variable. This ratio measures whether stocks are over (under)-valued relative to bonds and can act as a signal for portfolio managers. In-sample results reveal noticeable differences regarding the nature of relationships between the linear and non-linear setting, while results of a recursive forecasting exercise reveal both statistical and economic improvement over a linear model. Overall, these results support the view that non-linear estimates and forecasts can provide useful information for stock market traders, portfolio managers and policy-makers.

Date: 2012
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DOI: 10.1080/02692171.2011.580268

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