Switching between states and the COVID-19 turbulence

TL;DR

This paper introduces a state-switching model with an Aligned Economic Index to improve stock return predictability, demonstrating significant out-of-sample gains, especially during COVID-19 turbulence, benefiting both academics and practitioners.

Contribution

The paper develops a novel state-switching predictive model using an Aligned Economic Index, enhancing forecast accuracy across market regimes and during COVID-19 turbulence.

Findings

The Aligned Economic Index shows significant in-sample and out-of-sample predictive power.

The model outperforms traditional predictors during market regimes and COVID-19 turbulence.

Practitioners gain substantial economic benefits from using the new index.

Abstract

In Aarab (2020), I examine U.S. stock return predictability across economic regimes and document evidence of time-varying expected returns across market states in the long run. The analysis introduces a state-switching specification in which the market state is proxied by the slope of the yield curve, and proposes an Aligned Economic Index built from the popular predictors of Welch and Goyal (2008) (augmented with bond and equity premium measures). The Aligned Economic Index under the state-switching model exhibits statistically and economically meaningful in-sample ($R^2 = 5.9\%$) and out-of-sample ($R^2_{\text{oos}} = 4.12\%$) predictive power across both recessions and expansions, while outperforming a range of widely used predictors. In this work, I examine the added value for professional practitioners by computing the economic gains for a mean-variance investor and find substantial added benefit of using the new index under the state switching model across all market states. The Aligned Economic Index can thus be implemented on a consistent real-time basis. These findings are crucial for both academics and practitioners as expansions are much longer-lived than recessions. Finally, I extend the empirical exercises by incorporating data through September 2020 and document sizable gains from using the Aligned Economic Index, relative to more traditional approaches, during the COVID-19 market turbulence.