Timing the market: the economic value of price extremes

TL;DR

This paper empirically demonstrates that the asymmetry between potential maximum gain and loss, derived from price extremes, can significantly improve asset return predictions and provide substantial utility gains for investors.

Contribution

It introduces a novel decomposition of asset returns into PMG and PML, revealing a significant asymmetry that enhances return predictability across various markets.

Findings

PML significantly predicts PMG but not vice versa

Asymmetry improves both in-sample and out-of-sample return forecasts

The asymmetry remains robust across different countries and controls

Abstract

By decomposing asset returns into potential maximum gain (PMG) and potential maximum loss (PML) with price extremes, this study empirically investigated the relationships between PMG and PML. We found significant asymmetry between PMG and PML. PML significantly contributed to forecasting PMG but not vice versa. We further explored the power of this asymmetry for predicting asset returns and found it could significantly improve asset return predictability in both in-sample and out-of-sample forecasting. Investors who incorporate this asymmetry into their investment decisions can get substantial utility gains. This asymmetry remains significant even when controlling for macroeconomic variables, technical indicators, market sentiment, and skewness. Moreover, this asymmetry was found to be quite general across different countries.