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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.

Suggested Citation

  • Allan Timmermann & M. Hashem Pesaran, 2002. "Market Timing and Return Prediction under Model Instability," FMG Discussion Papers dp412, Financial Markets Group.
  • Handle: RePEc:fmg:fmgdps:dp412
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    References listed on IDEAS

    as
    1. 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, June.
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    JEL classification:

    • L81 - Industrial Organization - - Industry Studies: Services - - - Retail and Wholesale Trade; e-Commerce
    • F3 - International Economics - - International Finance
    • G3 - Financial Economics - - Corporate Finance and Governance
    • J1 - Labor and Demographic Economics - - Demographic Economics

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