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Market-timing the business cycle

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  • Peláez, Rolando F.

Abstract

As a group, professional portfolio managers have been largely unable to outperform the market buy-and-hold benchmark. Likewise, professional forecasters have been unable to predict recessions reliably. The paper contributes to the literature in two significant respects. First, the Recession Probability Model herein correctly forecasts out-of-sample the probability of a downturn and the binary state over a 45-year validation sample. This is important as it is around cyclical turning points that forecast errors are largest, and dependable forecasts are most useful. Reliable recession forecasts are essential for risk-management, planning capital outlays, and for portfolio management. Moreover, accurate forecasts of the turn allow policy-makers to mitigate the social cost of recessions. Second, the paper shows that it is extremely profitable to switch from equities to T-bills when the one-quarter-ahead probability of recession reaches a certain threshold. Several market-timing rules dominate the buy-and-hold in terms of the risk-adjusted measures of Treynor, Sharpe, and Jensen. One trading rule achieves triple the terminal wealth of the buy-and-hold.

Suggested Citation

  • Peláez, Rolando F., 2015. "Market-timing the business cycle," Review of Financial Economics, Elsevier, vol. 26(C), pages 55-64.
  • Handle: RePEc:eee:revfin:v:26:y:2015:i:c:p:55-64
    DOI: 10.1016/j.rfe.2015.03.003
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    References listed on IDEAS

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    Keywords

    Market-timing; Forecasting; Recessions;

    JEL classification:

    • C35 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Discrete Regression and Qualitative Choice Models; Discrete Regressors; Proportions
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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