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Market Timing and Return Prediction under Model Instability

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  • Allan Timmermann

    ()

  • M. Hashem Pesaran

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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File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmg_pdfs/dp412.pdf
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Bibliographic Info

Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp412.

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Date of creation: Mar 2002
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Handle: RePEc:fmg:fmgdps:dp412

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Web page: http://www.lse.ac.uk/fmg/

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