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Market timing and return prediction under model instability

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  • Pesaran, M. Hashem
  • Timmermann, Allan

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.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Empirical Finance.

Volume (Year): 9 (2002)
Issue (Month): 5 (December)
Pages: 495-510

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Handle: RePEc:eee:empfin:v:9:y:2002:i:5:p:495-510

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Web page: http://www.elsevier.com/locate/jempfin

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  1. Pesaran, M Hashem & Timmermann, Allan, 1992. "A Simple Nonparametric Test of Predictive Performance," Journal of Business & Economic Statistics, American Statistical Association, vol. 10(4), pages 561-65, October.
  2. Perron, P. & Bai, J., 1995. "Estimating and Testing Linear Models with Multiple Structural Changes," Cahiers de recherche 9552, Universite de Montreal, Departement de sciences economiques.
  3. Campbell, John Y., 1987. "Stock returns and the term structure," Journal of Financial Economics, Elsevier, vol. 18(2), pages 373-399, June.
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  9. Pesaran, M. H. & Timmermann, A., 1996. "A Recursive Modelling Approach to Predicting UK Stock Returns'," Cambridge Working Papers in Economics 9625, Faculty of Economics, University of Cambridge.
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  17. Brennan, Michael J. & Schwartz, Eduardo S. & Lagnado, Ronald, 1997. "Strategic asset allocation," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1377-1403, June.
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