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Market Timing and Return Prediction under Model Instability

  • Allan Timmermann

    ()

  • M. Hashem Pesaran

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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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
Contact details of provider: Web page: http://www.lse.ac.uk/fmg/

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  1. James H. Stock & Mark W. Watson, 1994. "Evidence on structural instability in macroeconomic times series relations," Working Paper Series, Macroeconomic Issues 94-13, Federal Reserve Bank of Chicago.
  2. Pesaran, M Hashem & Timmermann, Allan, 2000. "A Recursive Modelling Approach to Predicting UK Stock Returns," Economic Journal, Royal Economic Society, vol. 110(460), pages 159-91, January.
  3. Gabriel Perez-Quiros & Allan Timmermann, 2000. "Firm Size and Cyclical Variations in Stock Returns," Journal of Finance, American Finance Association, vol. 55(3), pages 1229-1262, 06.
  4. 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.
  5. Breen, William & Glosten, Lawrence R & Jagannathan, Ravi, 1989. " Economic Significance of Predictable Variations in Stock Index Returns," Journal of Finance, American Finance Association, vol. 44(5), pages 1177-89, December.
  6. Whitelaw, Robert F, 1994. " Time Variations and Covariations in the Expectation and Volatility of Stock Market Returns," Journal of Finance, American Finance Association, vol. 49(2), pages 515-41, June.
  7. Henriksson, Roy D & Merton, Robert C, 1981. "On Market Timing and Investment Performance. II. Statistical Procedures for Evaluating Forecasting Skills," The Journal of Business, University of Chicago Press, vol. 54(4), pages 513-33, October.
  8. Pesaran, M.H. & Timmermann, A., 1990. "A Simple, Non-Parametric Test Of Predictive Performance," Cambridge Working Papers in Economics 9021, Faculty of Economics, University of Cambridge.
  9. Michael W. Brandt, 1999. "Estimating Portfolio and Consumption Choice: A Conditional Euler Equations Approach," Journal of Finance, American Finance Association, vol. 54(5), pages 1609-1645, October.
  10. Allan Timmermann & Halbert White & Ryan Sullivan, 1998. "Data-Snooping, Technical Trading, Rule Performance and the Bootstrap," FMG Discussion Papers dp303, Financial Markets Group.
  11. Jushan Bai & Pierre Perron, 1998. "Estimating and Testing Linear Models with Multiple Structural Changes," Econometrica, Econometric Society, vol. 66(1), pages 47-78, January.
  12. Pesaran, M Hashem & Timmermann, Allan, 1995. " Predictability of Stock Returns: Robustness and Economic Significance," Journal of Finance, American Finance Association, vol. 50(4), pages 1201-28, September.
  13. Kandel, Shmuel & Stambaugh, Robert F, 1990. "Expectations and Volatility of Consumption and Asset Returns," Review of Financial Studies, Society for Financial Studies, vol. 3(2), pages 207-32.
  14. Campbell, John Y., 1987. "Stock returns and the term structure," Journal of Financial Economics, Elsevier, vol. 18(2), pages 373-399, June.
  15. Kandel, Shmuel & Stambaugh, Robert F, 1996. " On the Predictability of Stock Returns: An Asset-Allocation Perspective," Journal of Finance, American Finance Association, vol. 51(2), pages 385-424, June.
  16. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-36, May-June.
  17. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
  18. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
  19. Ferson, Wayne E, 1989. " Changes in Expected Security Returns, Risk, and the Level of Interest Rates," Journal of Finance, American Finance Association, vol. 44(5), pages 1191-1217, December.
  20. Bossaerts, Peter & Hillion, Pierre, 1999. "Implementing Statistical Criteria to Select Return Forecasting Models: What Do We Learn?," Review of Financial Studies, Society for Financial Studies, vol. 12(2), pages 405-28.
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