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Regime switching in stock market returns

  • Huntley Schaller
  • Simon Van Norden

An extension of Hamilton's Markov switching techniques (Hamilton, J. B., 1989, A new approach to the economic analysis of nonstationary time series and the business cycle, Econometrica, 57, 357-84) is used to describe and analyse stock market returns. Using new tests, very strong evidence is found for switching behaviour. A major innovation is to use a multivariate specification that allows examination of whether the price/dividend ratio has marginal predictive power for stock market returns after accounting for state-dependent switching. We find strong evidence of predictability. The response of returns to the past price/dividend ratio is strongly asymmetric - about four times larger in the low-return state than in the high-return state. A second innovationis to allow the probability of transitions from one regime to another to depend on economic variables; again there is an asymmetric response to the past price/dividend ratio.

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Article provided by Taylor & Francis Journals in its journal Applied Financial Economics.

Volume (Year): 7 (1997)
Issue (Month): 2 ()
Pages: 177-191

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Handle: RePEc:taf:apfiec:v:7:y:1997:i:2:p:177-191
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