The Aligned Economic Index & The State Switching Model

TL;DR

This paper introduces a state-switching model for U.S. stock return predictability using the yield curve slope to define market states, and proposes the Aligned Economic Index, which enhances predictive accuracy across economic regimes.

Contribution

It develops a novel state-switching predictive regression and introduces the Aligned Economic Index, improving out-of-sample stock return forecasts over existing predictors.

Findings

State-dependent expected returns are significant across economic regimes.

The state-switching model improves predictive performance for popular predictors.

The Aligned Economic Index outperforms benchmark predictors in both in-sample and out-of-sample tests.

Abstract

A growing empirical literature suggests that equity-premium predictability is state dependent, with much of the forecasting power concentrated around recessionary periods (Henkel et al., 2011; Dangl and Halling, 2012; Devpura et al., 2018). I study U.S. stock return predictability across economic regimes and document strong evidence of time-varying expected returns across both expansionary and contractionary states. I contribute in two ways. First, I introduce a state-switching predictive regression in which the market state is defined in real time using the slope of the yield curve. Relative to the standard one-state predictive regression, the state-switching specification increases both in-sample and out-of-sample performance for the set of popular predictors considered by Welch and Goyal (2008), improving the out-of-sample performance of most predictors in economically meaningful ways. Second, I propose a new aggregate predictor, the Aligned Economic Index, constructed via partial least squares (PLS). Under the state-switching model, the Aligned Economic Index exhibits statistically and economically significant predictive power in sample and out of sample, and it outperforms widely used benchmark predictors and alternative predictor-combination methods.