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

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  • Zhu, Xiaoneng
  • Zhu, Jie
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    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.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 37 (2013)
    Issue (Month): 11 ()
    Pages: 4120-4133

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    Handle: RePEc:eee:jbfina:v:37:y:2013:i:11:p:4120-4133

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

    Related research

    Keywords: Stock returns; Predictability; Regime switching; Uncertainty; Time-varying predictability;

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