Market Timing and Return Prediction under Model Instability

Allan Timmermann and Mohammad Pesaran

FMG Discussion Papers from Financial Markets Group

Abstract: Despite mounting empirical evidence to the contrary, the literature on predictability of stock returns almost uniformly assumes a time-invariant relationship between state variables and returns. In this paper we propose a two-stage approach for forecasting of financial return series that are subject to breaks. The first stage adopts a reversed ordered Cusum (ROC) procedure to determine in real time when the most recent break has occurred. In the second stage, post-break data is used to estimate the parameters of the forecasting model. We compare this approach to existing alternatives for dealing with parameter instability such as the Bai-Perron method and the time-varying parameter model. An out-of-sample forecasting experiment demonstrates considerable gains in market timing precision from adopting the proposed two-stage forecasting method.

Date: 2002-03
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Citations: View citations in EconPapers (138)

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Related works:
Journal Article: Market timing and return prediction under model instability (2002)
Working Paper: Market timing and return prediction under model instability (2002)
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Persistent link: https://EconPapers.repec.org/RePEc:fmg:fmgdps:dp412

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