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∗

Erik Kole†

Dick J.C. van Dijk

Econometric Institute, Erasmus School of Economics, Erasmus University Rotterdam

February 1, 2012

Abstract

This paper compares fundamentally different methods to identify and predict

the state of the equity market. Because this state is a comprehensive economic

indicator, good identification and prediction are important for financial decisions

and economic analyses. We consider rules-based methods that purely reflect the

direction of the market, and regime-switching models that take both average returns

and volatility into account. Because the state of the equity market is latent, we

develop a novel framework for statistical and economic comparisons of the different

methods. Rules-based methods are preferable for identification, because ex post only

the direction of the market matters. Regime-switching models perform significantly

better in making predictions. Focusing on average returns and volatilities leads to

more prudent forecasts and a higher utility from the perspective of risk-averse investor

who engages in market timing. Both the statistical and economic distance measures

indicate that these differences are significant.

∗

We thank Christophe Boucher, Thijs Markwat and seminar participants at the 8th International Paris

Finance Meeting, Inquire’s UK Autumn Seminar 2010 and Erasmus University for helpful comments and

discussions. We thank Anne Opschoor for skillful research assistance and Inquire UK for financial support.

Kole thanks the Netherlands Scientific Organisation (NWO) for financial support.

†

Corresponding author. Address: Burg. Oudlaan 50, Room H11-13, P.O. Box 1738, 3000DR Rot-

terdam, The Netherlands, Tel. +31 10 408 12 58. E-mail addresses kole@ese.eur.nl (Kole) and

djvandijk@ese.eur.nl (Van Dijk).

1

1 Introduction

The state of the equity market, often referred to as bullish or bearish, is an important

variable in finance and more generally in economic analysis. Despite its importance, the

literature does not offer a single preferred method to identify and predict the state of the

equity markets. In this paper, we compare several existing methods that can identify and

predict bull and bear markets. These methods differ in their use of the characteristics of

bull and bear markets. During bull markets prices gradually rise and volatility is low, while

during bear markets prices can fall dramatically and volatility is high. Our comparison

offer the main insight that for ex post identification, methods that focus explicitly on price

increases and decreases work best, whereas for ex ante predictions, methods that combine

the trend in prices with volatility are preferable.

Information on the state of the equity market is obviously relevant for agents who are

closely involved in financial markets. Investors may follow a market timing strategy, with a

long position in the equity market when it is bullish, and a neutral or short position position

when it is bearish. Investors that do not engage in market timing strategies can incorporate

the different behavior of stock returns dependent on market sentiment (see Perez-Quiros

and Timmermann, 2000) in their risk management. Firms prefer to issue new equity during

bull markets. For regulators, the state of the equity market is important, because it can

affect the credit supply with destabilizing effects on the real economy. When financial

assets are used as collateral, bull markets extend the credit supply, while bear markets

reduce it (see Rigobon and Sack, 2003; Bohl et al., 2007). Finally, bull and bear markets

impact asset pricing, as they are an important source for time variation in risk premia (see,

for example, Veronesi, 1999; Gordon and St-Amour, 2000; Ang et al., 2006).

The importance of bull and bear markets concerns economic analysis in general, and

not just investments. As argued by Stock and Watson (2003a), stock prices can predict

macroeconomic variables, as they are discounted future dividends. As far back as Mitchell

and Burns (1938), the state of the stock market is considered as an ingredient for leading

indicators of the business cycle (see Marcellino, 2006, for an overview). Harvey (1989); Es-

trella and Mishkin (1998); Chauvet (1999) and Stock and Watson (2003b) report evidence

that the state of stock market helps predicting the business cycle.

2

The literature offers two fundamentally different types of methods to identify and pre-

dict the state of equity markets: non-parametric ones based on rules and fully paramet-

ric ones based on models. Rules-based methods are more transparent than model-based

methods that need statistical inferences, and more robust to misspecification. On the other

hand, a completely specified model for the price process on the equity market offers more

insight and its quality can be evaluated by statistical techniques, whereas rules-based meth-

ods typically require some arbitrary, subjective settings. As a final difference, model-based

techniques are statistically more efficient, because they treat identification and prediction

in one step, whereas rules-based methods are two-step approaches.

We develop new techniques to compare the identifications and predictions of the dif-

ferent methods. Existing techniques, for example to test for predictive ability, do not

suffice, because the state of the equity market is latent. There is no generally accepted

chronology of bull and bear markets like the NBER chronology of recessions. To deter-

mine the difference between identifications and predictions of the methods, we propose a

general statistical distance measure and a more specific economic measure. As a statistical

measure we propose the Integrated Absolute Difference (IAD) between identifications or

predictions. It is closely related to the Integrated Square Difference of Pagan and Ullah

(1999) and Sarno and Valente (2004), though easier to interpret as a difference in probabil-

ity. The economic measure quantifies the preference for an method over another method.

We determine this measure as the fee that a risk-averse investor would maximally pay to

switch from one method to another to engage in marketing timing.

In the category of rules-based methods, we consider Pagan and Sossounov (2003) and

Lunde and Timmermann (2004). These non-parametric methods first determine local

peaks and troughs in a time series of asset prices, and then use rules to select those

peaks and troughs that constitute genuine turning points between bull and bear markets.

They are based on the algorithms used to date recessions and expansions in business cycle

research (see Bry and Boschan, 1971, among others), and have been adapted in different

ways for application in financial markets. The main rule in Pagan and Sossounov (2003)

is the requirement of a minimum length of bull and bear cycles and phases.1 By contrast,

1

See Edwards et al. (2003); Gómez Biscarri and Pérez de Gracia (2004); Candelon et al. (2008); Chen

(2009) and Kaminsky and Schmukler (2008) for applications.

3

Lunde and Timmermann (2004) impose a minimum on the price change since the last peak

or trough.2

In the second category, we analyze Markov regime-switching models pioneered by

Hamilton (1989, 1990). In these models returns behave differently, depending on a discrete

latent state process that follows a Markov chain. We consider models with two and with

three distinct states. Conditional on the state, returns follow a normal distribution. Em-

pirical applications typically distinguish two regimes with different means and variances

and normally distributed innovations.3 The bull (bear) market regime exhibits a high (low

or negative) average return and low (high) volatility. The number of regimes can easily be

increased to improve the fit of the model (see Guidolin and Timmermann, 2006a,b, 2007)

or to model specific features of financial markets such as crashes (see Kole et al., 2006) or

bull market rallies (see Maheu et al., 2009). We follow the literature and consider models

with two and with three regimes.

A comparison of the identification of the state of the US stock market, proxied by the

S&P 500, over the period 1955-2010 shows a preference for the rules-based methods. The

rules-based methods simply separate periods with price increases from periods with price

decreases. The regime-switching models identify periods where the risk-return trade-off

is attractive, a positive mean and low volatility, or unattractive, a negative mean and

high volatility. However, periods with high volatility are sometimes labeled bearish, even

if they exhibit positive average returns. Periods with negative average returns may be

labeled bullish as long as the volatility is low. The IADs indicate that the rules-based and

model based methods produce identifications that are significantly different. A risk-averse

investor would pay up to 20% per year to time the market based on a rules-based method.

This fee is significant, but should be interpreted with care as it corresponds with perfect

foresight.

Because the state of the equity market is a comprehensive economic indicator, predicting

it well may be more important than identifying it. We set up a forecasting experiment,

where predictions are made from July 1983 onwards. From a utility perspective, regime-

2

Chiang et al. (2009) adopt this method.

3

See for instance Hamilton and Lin (1996); Maheu and McCurdy (2000); Chauvet and Potter (2000);

Ang and Bekaert (2002); Guidolin and Timmermann (2008a) and Chen (2009) for applications.

4

switching models are preferable. They make prudent forecasts and yield highest utility. A

market timing strategy based on regime switching models produces lower volatility than

based on rules. The maximum fee to switch to a regime switching model from a rules-based

methods is around 16% and significant. However, looking at Sharpe ratios, the method

of Lunde and Timmermann (2004) shows the best performance, with an average return of

8.7% in excess of the risk-free rate and a volatility 32.4%. The resulting Sharpe ratio of

0.27 compares favorably to the Sharpe ratio of a long position in the market at 0.21. The

best performing regime-switching model yields a Sharpe ratio of 0.15. The IADs indicate

that the predictions by the methods of Lunde and Timmermann (2004), of Pagan and

Sossounov (2003), and by the regime switching models are all significantly different.

The different results for identifications and predictions show that quickly picking up

bull-bear changes is crucial. The sooner a switch is identified, the larger the gains. With

perfect foresight, switches are identified immediately. When predictions have to be made,

the methods detects switches with some delay, and the performance is less. Regime switch-

ing models are fastest in this respect, which partly explains their good performance. The

methods of Pagan and Sossounov (2003) rapidly picks up switches, but produces many

costly false alarms.

We investigate whether inclusion of macro-financial variables improves the predictions

of the different methods, but find that the effects are at best marginal. We use a specific-to-

general selection procedure to include those predictive variables that work best in-sample.

For the rules-based approaches their use consistently lowers performance, whereas perfor-

mance improves when predictive variables are included in the transition probabilities of

the regime-switching models (see Diebold et al., 1994). While the IAD indicate significant

statistical differences, the fees indicate that the value of these differences are small and

insignificant.

Our research relates directly to the debate between Harding and Pagan (2003a,b) and

Hamilton (2003) on the best method to date business cycle regimes. Harding and Pagan

advocate simple dating rules to classify months as a recession or expansion, while Hamil-

ton proposes regime switching models. In the dating of recessions and expansions, both

methods base their identification mainly on the sign of GDP growth and produce compa-

rable results. For dating bull and bear periods in the stock market by regime switching

5

models, the volatility of recent returns seems at least as important (if not more) than

their sign. Consequently, their identifications and predictions differs substantially from

the rules-based approaches.

We also add to the discussion on predictability in financial markets. We extend the anal-

ysis of Chen (2009) in several ways. First, we consider the dynamic combination of more

predictive variables. Second, we include predictive variables directly in the regime switch-

ing models and do not need Chen (2009)’s two-step procedure. He treats the smoothed

inference probabilities as observed dependent variables in a linear regression, which does

not take their probabilistic nature into account. Our results for the rules-based approaches

show that the in-sample added value of the predictive variables is not met with out-of-

sample quality. Strategies with predictive variables perform worse than those without.

For the regime switching models, we find quite some variation in the selected variables

and their coefficients. Taken together, these results are in line with those documented by

Welch and Goyal (2008) for direct predictions of stock returns.

The state of the equity market is an important variable when making investments and

for economic decision making in more general. Unfortunately, this state and its process

is latent. An economic agent who wants to infer it, can typically choose between non-

parametric and parametric methods. The non-parametric methods consist of sets of rules.

The parametric techniques are based on models that specify the distribution of stock re-

turns conditional on the state of the stock market and the dynamics of the state. Specifying

a model implies the risk of misspecification, to which non-parametric techniques are more

robust. On the other hand, a parametric setting offers statistical techniques to assess the

quality of the model. Harding and Pagan (2002a) discuss similar issues with respect to

business cycle dating.

As rules-based methods, we consider the algorithms proposed by Lunde and Timmer-

mann (2004) and by Pagan and Sossounov (2003). Both methods identify bull and bear

markets by peaks and troughs in a price series. They differ in their selection of peaks

and troughs that constitute the actual switch points between bull and bear markets. The

6

model-based methods we consider are Markov regime-switching models as pioneered by

Hamilton (1989, 1990). In this approach, the state of the stock market follows a first order

Markov process with a specified number of regimes. The number of regimes can be set

equal to two (a bullish and bearish regime) or larger. More states can be introduced, for

example to capture sudden booms and crashes as in Guidolin and Timmermann (2006b,

2007) and Kole et al. (2006) or bear market rallies and bull market corrections as in Maheu

et al. (2009). In this paper, we write Stm to denote the state of the equity market at time

t for method m.

In the algorithm of Lunde and Timmermann (2004, LT henceforward), peaks and troughs

have to meet minimum requirements on their magnitude to qualify as switch points between

bull (between a trough and the subsequent peak) and bear markets (between a peak and the

subsequent trough). A bull (bear) market occurred if the index has increased (decreased)

by at least a fraction λ1 (λ2 ) since the last trough. The identification of peaks and troughs

in a price series {Pt }Tt=1 uses an iterative search procedure that starts with a peak or trough.

The identification rules can be summarized as follows:

1. The last observed extreme value was a peak with index value P max . The agent

considers the subsequent period.

(a) If the index has exceeded the last maximum, the maximum is updated.

(b) If the index has dropped by a fraction λ2 , a trough has been found.

2. The last observed extreme value was a trough with index value P min. The agent

considers the subsequent period.

(a) If the index has dropped below the last minimum, the minimum is updated.

(b) If the index has increased with a fraction λ1 , a peak has been found.

7

After these decision rules the agent considers the next period.

We follow LT by setting λ1 = 0.20 and λ2 = 0.15. This implies that an increase of

20% over the last trough signifies a bull market, and that a decrease of 15% since the last

peak indicates a bear market. To commence the search procedure we determine whether

the market is initially bullish of bearish. We count the number of times the maximum and

minimum of the index have to be adjusted since the first observation. If the maximum has

to be adjusted three times first, the market starts bullish, otherwise it starts bearish.

The second approach has been put forward by Pagan and Sossounov (2003, PS hence-

forward). Their approach is based on the identification of business cycles in macroeconomic

data (see also Harding and Pagan, 2002b). They also use peaks and troughs to mark the

switches between bull and bear markets. However, their identification is quite different

from LT. PS do not impose requirements on the magnitude of the change of the index, but

instead put restrictions on the minimum duration of phases and cycles. Their algorithm

consists of five steps

1. Locate all local maxima and minima in a price series. A local maximum (minimum)

is higher (lower) than all prices in the past and future τwindow periods.

maxima and lowest minima.

3. Censor peaks and troughs in the first and last τcensor periods.

4. Eliminate cycles of bull and bear markets that last less than τcycle periods.

5. Eliminate bull market or bear markets that lasts less than τphase periods, unless the

absolute price change exceeds a fraction ζ.

We mostly follow PS for the values of these parameters, adjusted for the weekly fre-

quency of our data. We have τwindow = 32, τcycle = 70, τphase = 16 and ζ = 0.20 (see

also PS, Appendix B). We censor switches in the first and last 13 weeks, opposite to the

26 weeks taken by PS. Censoring for 26 weeks would mean that only after half a year an

investor can be sure whether a bear or a bull market prevails, which we consider a very

8

long time. Since we will use this information in making predictions, we use a shorter period

of 13 weeks to establish the initial and the ultimate state of the market.

In both methods, the next step is to relate the resulting series of bull and bear states to

a set of explanatory variables, zt−1 . We code bull markets as Stm = u and bear markets as

Stm = d. Since the dependent variable is binary, a logit or probit model can be used. We

opt for a logit model, as this model can be easily extended to a multinomial logit model

when more states are present. We adjust the standard logit model such that the effect

of an explanatory variable on the probability of a future state can depend on the current

state. Some macro-finance variables may have a different (or no) effect on the probability

of a switch from a bull market than from a bear market. The probability for a bull state

to occur at time t is modeled as

m

πqt ≡ Pr[Stm = u|St−1

m

= q, zt−1 ] = Λ(βqm ′ zt−1 ), m = LT, PS, q = u, d (1)

where Λ(x) ≡ 1/(1 + e−x ) denotes the logistic function, and βqm is the coefficient vector on

the zt−1 variables, which depends on the previous state of the market q. For notational

convenience, we assume the first variable in zt−1 is a constant to capture the intercept

term. We call this model a Markovian logit model, as it combines a logit model with the

m

Markovian property that the probability distribution of the future state St+1 is (partly)

determined by Stm . If the coefficient βqm does not depend on q, a normal logit model results.

If only a constant is used, the market state process is a standard stochastic process with

the Markov property.

To form the one-period ahead prediction for πTm+1 , the prevailing state at time T is

needed. For the rules-based approaches, this information may not be available. In the

LT-approach, only if PT equals the last observed maximum (minimum), and is a fraction

λ1 above (λ2 below) the prior minimum is the market surely in a bull (bear) state. The PS-

alogirthm suffers from this problem too, since only the state up to the last τcensor periods is

known. So, the market may already have switched, but this will only become obvious later.

In that case, the state of the market is known until the period of the last extreme value,

9

which we denote by T ∗ < T . We construct the one-period ahead prediction recursively

m m

Pr[St+1 = s|zt ] = Pr[St+1 = s|Stm = u, zt ] Pr[Stm = u|zt−1 ]+

m

Pr[St+1 = s|Stm = d, zt ] Pr[Stm = d|zt−1 ], T ∗ < t ≤ T + 1. (2)

Starting with the known state at T ∗ , we construct predictions for T ∗ + 1, which we use for

the predictions of T ∗ + 2 and so on. This iteration stops at T + 1.

We also consider a method for identifying and predicting bull and bear markets that is

fundamentally different from the algorithms considered in the previous section. Instead

of applying a set of rules to a given series, we now first write down a model that can be

the data generating process of a stock market index that allows for prolonged bullish and

bearish periods. Estimating such a model produces probabilistic inferences on periods of

bull and bear markets in a certain index.

Using such a model-based approach has several advantages. First, it offers more insight

into the process under study. We can derive theoretical properties of the model and see

whether it yields desirable features. Second, we can easily extend the number of states in

the model. We can test whether such extensions imply significant improvements. A third

advantage is the ease with which we can compare results for different markets and different

time periods. Models can typically be summarized by their coefficients, whereas a simple

characterization of the rule-based results may not be straightforward. The advantages come

at the cost of misspecification risk. In particular (missed or misspecified) changes in the

data generating process can have severe impact on the results. As rule-based approaches

do not make strict assumptions on distributions or on the absence or presence of variation

over time, they may be more robust.

We consider several Markov chain regime switching models for the stock market, having

k regimes (used as first suffix) and having either constant or time-varying probabilities

(suffix C or L). For example, the label RS3L means a Markov regime switching model with

three states and time-varying transition probabilities. Based on the results of Guidolin

and Timmermann (2006a, 2007, 2008b), we consider k = {2, 3}, and use S m to denote the

10

set of regimes.

We assume that the excess index return rt follows a normal distribution in each regime

s with regime specific means and variances,

rt ∼ N(µm m

s , ωs ), s ∈ S

m

(3)

We order the regimes based on the estimated means. While asymmetric or fat-tailed distri-

butions can be used for the regimes, Timmermann (2000) shows that the mixtures implied

by regime switching models constituted by normal distributions can flexibly accommodate

these features.

Our approach differs from Maheu et al. (2009). These authors allow for bear markets

that can exhibit short rallies and bull markets that can show brief corrections. They enable

identification by imposing that the expected return during bear markets including rallies

is negative, while it is positive during bull markets including corrections. This setup can

improve identification, though the added value for prediction is less obvious. The difference

in the predicted return distributions between a bull market and a bear market rally is likely

to be small.

Since the actual state of the market is not directly observable, we treat it as a latent

variable that follows a first order Markov chain with transition matrix Ptm that can vary

over time. This matrix contains parameters

m

πqst ≡ Pr[Stm = s|St−1

m

= q, zt−1 ], s, q ∈ S m . (4)

P m

Of course, the restrictions ∀q, ∀t : πsqt

s∈S m = 1 applies. When the transition probabili-

˙ − 1) free parameters to be estimated. If

ties are kept constant, this restriction leaves k (k

the probabilities are time-varying, we use a multinomial logit specification

m′

m eβqs zt−1

πqst =P m ′z

βqς

, s, q ∈ S m , (5)

ς∈S e t−1

multinomial specification reduces to the standard logit specification

m

πqt ≡ Pr[Stm = u|St−1

m

= q, zt−1 ] = Λ(βqm ′ zt−1 ), m = RS2L. (6)

11

This specification is mathematically similar to the logit models for the rules based ap-

proaches in Eq. (1), though it is an integrated part of the regime switching model.

We finish by introducing parameters for the probability that the process starts in a

P

specific state, ξsm ≡ Pr[S1m = s]. Again the restriction s∈S m ξsm = 1 should be satisfied.

We treat the remaining parameters as free, and estimate them.

We estimate the parameters of the resulting regime switching model by means of the

EM-algorithm of Dempster et al. (1977). To determine the optimal parameters describing

the distribution per state, we follow the standard textbook treatments (e.g., Hamilton,

1994, Ch. 24). In appendix A we extend the method of Diebold et al. (1994) to estimate

the parameters of the multinomial logit specification.

We want to establish the difference of the results of the various approaches and test for

their significance. This comparison is complicated by the latent nature of the true regime.

Neither does an accepted reference list of bull and bear markets exist, contrary to for

example the NBER list of recessions and expansions, which is used in the business cycle

literature. As a consequence, standard ways to compare the different identifications do

not avail. The evaluation of predictions suffers from the same problem. Because the true

chronology of bull and bear markets is latent a prediction can never be classified as true

or false. We cannot apply existing tests for predictive ability, which define a loss function

over the realization and the prediction of a certain variable.4

Instead, we propose a new framework that builds on the probabilities for the different

states of the market. For a purely statistical comparison, we propose a statistic that is

based on the absolute difference between the probability vectors that result from different

methods. While this statistic indicates how different two methods are, it does not point

out which one is better. Therefore, we develop a second statistic that is based on economic

decision-making. We consider an investor who wants to time the market, and derive the

maximal fee that would make her ex post indifferent towards two methods. Both statistics

4

See for example Diebold and Mariano (1995); West (1996); White (2000); Corradi and Swanson (2007).

12

can be used for the identification and the predictions that the methods produce.

The basis for both statistics is the interpretation of the different approaches as filters.

Each algorithm m applies a filter

time t1 . The information set contains a return series and a set of explanatory variables,

Ωt = {(rτ , zτ )}tτ =1 .5 If t1 > t2 , this probability vector can be interpreted as a forecast

probability. If the information set comprises all available information, denoted by ΩT , the

likelihood corresponds with identification, and we call it an inference probability. The filter

may use parameters β̂ m ≡ β̂ m (Ωt3 ) that are estimated using the information set Ωt3 with

t3 ≤ t2 , or exogenously specified parameters θ m , for example the boundaries λ1 and λ2 in

the LT-algorithm. In case of the rules based approaches, the state at time t is identified

as either bullish or bearish, so F m : (t, ΩT ; θ m ) = (1, 0)′ or (0, 1)′ for m = LT, PS. If

regime switching models are used, the identification comes from the smoothed inference

probabilities (see Hamilton, 1994, Ch. 22).

Comparing the results of two different filters F m (t1 , Ωtm

2

; β̂ n , θ n ) and F n (t1 , Ωtn2 ; β̂ m , θ m )

is equivalent to comparing the two resulting probability vectors pm and pn . The difference

between pm and pn can come from a different filter algorithms F or from information sets

of different length Ωtm

2

or Ωtn2 . There should be a function g : (pm , pn ) → R, whose outcome

can be interpreted as a difference. So, a larger absolute value for g(pm, pn ) should indicate

a larger difference. When a statistical measure is used, the function g is closely related to

pm and pn . For an economic comparison, the function g is defined in the context of the

economic decision-making that is considered.

As pointed out by Pesaran and Skouras (2002), statistically based and economically

based comparisons both have their merits. The statistical comparison is more general, and

5

The rules-based approaches actually work with prices series to define peaks and troughs. To determine

turning points, subsequent rules based on returns are applied. The regime-switching method are completely

based on returns. From a statistical point of view, a stationary information set is advantageous. Therefore,

we assume that a set of returns is included in Ωt . Since the initial index value P̃0 does not influence the

results of the rules-based approaches, it does not matter whether a prices series or a return series is taken

as input.

13

can be relevant in various circumstances. In contrast, an economic comparison relates the

comparison to a specific decision problem, and can take into account that the consequences

of decisions can be asymmetric. Wrong decisions may be more harmful than good decisions

are beneficial. By using cost functions or utility functions (as in Granger and Pesaran, 2000;

West et al., 1993), such a measure can be easily linked to economic theory. A novelty in our

use of these concepts is their application to compare identification, whereas the existing

literature relates them to evaluate forecasting accuracy.

We base our statistical distance measure on the L1-norm, corresponding with the absolute

difference. Calculating the difference between two methods of identification or prediction

would be easy, when the realization is known. Conditional on the realized state s, we would

calculate

d(pm , pn |S = s) ≡ |pm n

s − ps |. (8)

We can only compare two filters if their set of states coincide, S m = S n . If the sets do

not coincide, we can reduce the larger set by aggregating two or more states. We cannot

measure the difference between pm n

s and ps by the ratio of their logarithms as proposed

by Kullback and Leibler (1951) since either probability can equal zero or one, when we

consider identification in the rules-based approaches.

Since S is latent, we next integrate over the different k states,

X

d(pn , pm ) ≡ φs |pm n

s − ps |, (9)

s∈S

where φs ≡ Pr[S = s] is the probability that state s prevails under the true probability

measure. The weight of the difference between pm n

s and ps increases when state s is more

similar to the integrated square difference in Pagan and Ullah (1999) and Sarno and Valente

(2004). For the binomial case S m = S n = {u, d}, the above expression simplifies to

d(pn , pm ) = φu |pm n m n m m m n m n

u −pu |+φd |pd −pd | = φu |pu −pu |+(1−φu )|1−pu −(1−pd )| = |pu −pu |.

14

We estimate the expected value E[d(pn , pm )] by its sample equivalent

1 XX T

dbm,n ≡ φs,t |pm n

s,t − ps,t |, (10)

T − R + 1 t=R s∈S

where R is the first period for which we compare the probabilities. When we compare

identifications, we can use the full sample and typically have R = 1. For predictions,

R > 1 and the observations before R are used as in-sample period to estimate model

parameters. In the binomial case, φ is irrelevant. In the multinomial case we need to

make an assumption on φt . We can, for example, assume that φt = pm or φt = pn . dbm,n

t t

will depend on the choice for φt in a similar way as the Kullback-Leibler divergence (see

Kullback and Leibler, 1951). We propose a bootstrap to derive the variance of of dd m,n ,

We propose a slightly adjusted distance measure when pm n

s ∈ {0, 1} and ps ∈ [0, 1]. This

s corresponds with full-sample identification by the rules-based

methods and pns with predictions from the rules-based methods or identification as well

as predictions from the regime-switching models. When pm n

s = 1 and ps > 1/2, the two

approaches lead to the same rounded inference or prediction. In that case we would like

to have a zero distance, which means replacing pm n

s by ps . By a similar logic, we replace

pm n m n

s by 1 − ps when ps = 1 and ps ≤ 1/2. Together, it means we replace the conditional

0 if pm n

s = I(ps > 1/2)

˜ m n

d(p , p |S = s) = (11)

|1 − 2pns | otherwise,

To construct an economic measure for the difference between two predictions, we need

a framework that links the state probabilities to a decision, and a method to evaluate

this decision and compare it to another state probability. We take the perspective of an

investor who uses the predictions to speculate on the occurrence of bull or bear markets.

She speculates by taking long or short position in one-period futures contracts. While

15

other frameworks are possible, we think that this approach is direct and easy to interpret.

However, other approaches, for example using bull- and bear markets for macroeconomic

predictions, are also possible.

We assume the investor maximizes the expected value of her utility function U(W ).

We express her position as a fraction w of her initial wealth W0 . Her next-period wealth

equals W0 (1 + wr). We approximate the utility function to the second order around her

initial wealth W0 :

1

U(W0 (1 + wr)) ≈ U(W0 ) + U ′ (W0 )W0 wr + U ′′ (W0 )W02 w 2 r 2 . (12)

2

Since the current utility level does not influence the optimization, we can ignore the first

term. Dividing by U ′ (W0 )W0 produces a standardized utility function

1 U ′′ (W0 )W0 2 2 1

Ũ (W0 (1 + wr)) = wr + ′

w r = wr − γw 2 r 2 , (13)

2 U (W0 ) 2

where γ is the coefficient of relative risk aversion.

We choose a quadratic approximation instead of other fully specified utility functions

for two reasons. The rules-based approaches do not provide predictions on the complete

distribution of r, but just predict its sign. The quadratic approximation only requires an

estimate for the mean and the variance of the distribution. Second, this approximation fits

in nicely with the regime-switching models that reflect both the mean and variance in its

identification and predictions. Nonetheless, a similar approach with higher order moments

would be straightforward, see e.g. Harvey and Siddique (2000), Jondeau and Rockinger

(2006) or Guidolin and Timmermann (2008a).

First, we derive the optimal decision, given a vector with state probabilities pm

t . Max-

imizing the expected value of Eq. (13) produces the optimal portfolio

wtm = µm m

t /(γψt ), (14)

where µm m

t is the predicted mean and ψt the predicted raw second moment of rt+1 . Both

X

µm

t ≡ pm m

s,t µs (15)

s∈S m

X X

ψtm ≡ pm m

s,t ψs = pm m 2 m

s,t ((µs ) + ωs ), (16)

s∈S m s∈S m

16

where µm m m

s , ψs and ωs are the state-specific mean, raw second moment and variance for

model m.

Next, we evaluate the optimal portfolio produced by method m, by calculating the

unconditional expected utility with respect to the unconditional distribution Gr of rt+1 ,

m m 1 m 2

V (w ) = EGr wt rt+1 − γ(wt rt+1 ) . (17)

2

We determine the economic difference between two methods m and n by calculating the

fee that an investor would be willing to pay to use method m instead of n, and denote it

ηm,n . The fee is expressed relative to the investor’s wealth. Including the fee, wealth at

time t + 1 equals W0 (1 + wtm rt+1 − ηm,n ). The utility resulting from method m should, after

paying the fee, equal the utility resulting from method n,

m 1 m 2 n 1 n 2

EGr wt rt+1 − ηm,n − γ (wt rt+1 − ηm,n ) = EGr wt rt+1 − γ (wt rt+1 ) ,

2 2 (18)

m n m

1 2

⇔V (w ) − V (w ) − 1 − γ EGr [wt rt+1 ] ηm,n − γηm,n = 0

2

which can be solved analytically for ηm,n . If ηm,n > 0, the investor is willing to pay a

fee for adopting m instead of n, so she prefers method m over n. If λm,n is negative, it

can be interpreted as a compensation that the investor wants to receive for adopting an

apparent inferior method m instead of n. Consequently, ηm,n is not only a measure for

how different method m is from n, but also whether method m is more attractive to risk-

averse investors. The measure is not symmetric, so exchanging methods m and n does not

produce the negative of the original fee, ηn,m 6= −ηm,n , unless m = n. Based on series for

{wtm }Tt=R−1

−1

, {wtn }Tt=R−1

−1

and {rt }Tt=R , we can estimate ηd

m,n . As discussed in the previous

m,n .

While a fee and the closely related concept of a certainty equivalent return have been

used before to determine the economic value of investment strategies, we are the first to

adopt it as a test statistic. Fleming et al. (2001) and Marquering and Verbeek (2004)

calculate fees to compare dynamic investment strategies with a fixed benchmark of a static

buy-and-hold strategy. West et al. (1993) interpret the relative increase in initial utility

that would be needed to equate to expected utility levels of two strategies also as a fee,

while other papers, for example Das and Uppal (2003) and Ang and Bekaert (2002), refer

17

to it as a certainty equivalent return. Their approaches imply that the fee is paid up-

front and reduces the amount available for investment. Since the investment strategies we

consider are zero-cost, we deduct the fee from the investment return.

3.3 Bootstrap

Conventional asymptotic techniques may not avail to determine the distribution of dd

m,n or

ηd d

m,n for two reasons. First, the distribution of dm,n has a lower bound at 0. Hence, the

t and pt may exhibit a high

of autocovariances as proposed by Diebold and Mariano (1995). Therefore, we propose to

use the bootstrap. We implement the bootstrap in two ways, depending on whether we

compare the identification or predictions of different methods.

In both cases, we construct bootstrapped samples from the original information set ΩT ,

so including returns and predicting variables. To account for autocorrelation in these series,

we apply the stationary bootstrap of Politis and Romano (1994). When we compare the

different methods for identification, we use the bootstrapped sample ΩjT to calculate new

estimates β̂(ΩjT ) and to construct new series of inference probabilities. In turn, these lead

j

to bootstrapped estimates dd m,n and ηd

j

m,n . These set of bootstrapped estimates converges

to the true distributions and can be used for testing and the construction of confidence

intervals.

In the case of comparing predictions, we follow the approach of White (2000). We

resample from the second part of the information, starting from the first prediction R. So,

in this case the first part of the information set ΩjR−1 = ΩR−1 for each bootstrap j. We

create new series {pm,j T n,j T

t }t=R and {pt }t=R , but use the estimates from the original series.

j

With these series, we calculate bootstrap estimates dd

m,n and ηd

j

m,n and construct their

distribution.

18

4 Data and implementation

The state of the stock market should be determined against the benchmark of a riskless

investment. A riskless bank account Bt earns the risk-free interest rate rτf over period τ .

Starting with B0 = 1, the value of this bank account obeys

Y

t−1

Bt ≡ 1 + rτf . (19)

τ =0

From a stock market index Pt the relevant series to determine the state follows

The return on this index is the market return in excess of the risk-free rate. It also

corresponds with the return on a long position in a one-period futures contract on the

stock market index. Futures contracts are the natural asset to speculate on the direction

of the stock market, as they are cheap and easily available. Studying the excess market

index P̃t thus corresponds directly with the return on an investment opportunity.

Our analysis considers the US stock market, proxied by the S&P500 price index on a

weekly frequency. We splice together a time-series for the S&P500 by combining the data

of Schwert (1990) with the S&P500 series that the Federal Reserve Bank of St. Louis has

made available on FRED.6 Schwert’s data set runs from February 17, 1885 until July 2,

1962, whereas the FRED series starts on January 4, 1957 and is kept up-to-date. For the

risk-free rate we use the three-month T-Bill rate, also from FRED. This series starts on

January 8, 1954. Because of the availability of the predicting variables, the data sample

that we analyze starts on January 7, 1955.

We use weekly observations because of their good trade-off between precision and data

availability. Higher frequencies lead to more precise estimates of the switches between bull

and bear markets. On the other hand, data of predicting variables at a lower frequency

is available for a longer time-span. Weekly data does not cut back too much on the time

span, and gives a satisfactory precision.

6

We kindly thank Bill Schwert for sharing his data with us.

19

Figure 1 shows the excess stock price index for the US. The index has been set to 100

on 1/7/1955. The graph exhibits the familiar financial landmarks of the last sixty years.

We observe a clear alternation of periods of rise and decline in the 1950s and 1960s, the

prolonged slump during the late 1970s and early 1980s, the crash of 1987, the dramatic rise

during the IT-bubble of the late 1990s and the subsequent bust in 2000-2002, and finally

the fall during the recent credit crisis.

We consider macro-economic and financial variables to predict whether the next period

will be bullish or bearish. Our choice of variables is motivated by prior studies that have

reported the success of several variables for predicting the direction of the stock market.

Hamilton and Lin (1996), Avramov and Wermers (2006) and Beltratti and Morana (2006)

use business cycle variables like industrial production. Ang and Bekaert (2002) show the

added value of the short term interest rate. Avramov and Chordia (2006) provide evidence

favoring the term spread and the dividend yield. Chen (2009) considers a wide range of

variables with the term spread, the inflation rate, industrial production and change in

unemployment being the most successful.

We join this literature and gather data accordingly for inflation, industrial production,

unemployment, the T-Bill rate, the term and credit spread, and the dividend-to-price ratio.

To ensure stationarity, we transform some of the predictive variables. The T-Bill rate and

the D/P-ratio exhibit a unit root. We construct a stationary series by subtracting the prior

one-year average from each observation, used more often in forecasting (see e.g., Campbell,

1991; Rapach et al., 2005). For the unemployment rate we construct yearly differences.

We transform the industrial production series to yearly growth rates. We do not transform

the inflation, the term spread or the credit spread series. To ease the interpretation of

coefficients on these variables, we standardize each series. As a consequence, coefficients

all relate to a one-standard deviation change and the economic impact of the different

variables can be compared directly. In Appendix B we provide more information on the

predictive variables.

20

The data for inflation, industrial production and unemployment is available at a monthly

frequency, dating back to 1950 or earlier. We lag this data by one month, and assume that

the series are constant within a month. For the T-Bill rate, weekly observations are avai-

lable from January 8, 1954. Since we consider the T-Bill rate as a difference to it’s yearly

moving average, this sets the starting date one year later, which also determines the starting

date for our analysis. Weekly observations of the term and credit spreads become available

from January, 1962. Before that date, we use monthly observations. The D/P-ratio is

available at a weekly frequency for all of our sample period. We lag weekly observations

by one week.

Because the predicting variables have a mixed frequency, we combine the stationary

bootstrap of Politis and Romano (1994) discussed in Section 3.3 with a block-bootstrap.

We apply the stationary bootstrap on a monthly frequency. If a certain month is drawn,

we draw all four or five corresponding weekly observations.

We consider in total seven variables that can help predicting the future state of the stock

market. Not all these variables might be helpful in predicting specific transitions. There-

fore, we propose a specific-to-general procedure for variable selection. In both the rules-

based and the regime switching approaches we start with a model with only constants

included. Next, we calculate for each variable and transition combination the improve-

ment its inclusion would yield in the likelihood function. We select the variable-transition

combination with the largest improvement and test whether this is significant with a like-

lihood ratio test. If the improvement is significant, we add the variable to our specification

for that specific transition and repeat the search procedure with the remaining variables-

transition combinations. The procedure stops when no further significant improvement is

found.

This approach differs from the general-to-specific approach, which would include all

variables first and then consider removing the variables with insignificant coefficients. For

the RS3L-model, we would need to estimate a model with 3 · 2 · 7 = 42 transition coeffi-

cients, which is typically infeasible. For the same reason, we do not follow Pesaran and

21

Timmermann (1995), who compare all different variable combinations based on general

model selection criteria such as AIC, BIC and R2 .

We first compare the identification of the different methods for the full sample. This

comparison shows in detail for the largest available information set how and why the

outcomes of the various methods differ. We consider the actual dating of bull and bear

markets, but also their durations and the return distributions. The IAD and switching fee

allow us to summarize these differences in a single number.

Figure 2 shows which periods are qualified as bullish (white area) or bearish (pink area)

by the different methods. We report summary statistics on the duration of bull and bear

markets in Table 1. The LT-method produces 16 cycles that are spread over our sample

period. Since the LT-algorithm is based on peaks and troughs, switches all take place at

maxima and minima. In the periods 1955–1970 and 1985–2000 long bull markets and short

bear markets alternate. In the period 1970–1985 bear markets dominate and prices decline

over the years. After 2000, we see bear market periods with pronounced declines in prices.

Bull markets last slightly over two years on average; bear markets slightly longer than one

year. However, the variation in duration is large.

by the LT-method, but is not identical. The PS-method shows more bull and bear markets

(19 and 18). The PS-method imposes minimal duration on bull and bear markets instead of

minimal changes, so it identifies some bull and bear markets that do not pass the hurdles

of the LT-model. On the other hand, the LT-method identifies some bull-bear market

cycles that last too short to be picked up by the PS-method. The shortest bull (bear)

market from the LT-method lasts 15 (7) weeks, compared to 27 (15) from the PS-method.

22

However, average duration is lower for the PS-method, since it identifies more cycles. The

variation in duration remains large.

In Figures 2(c–d) we show the identification by the RS2-models. We estimate the

model parameters, and use them to calculate smoothed inference probabilities at each

point in time. The smoothed inference probability for a bull market at time t gives the

probability that a bullish regime prevails, based on the full sample. We plot the series of

bull probabilities by a thin black line. We see that the probability for a bull market is

either close to one or close to zero, and rarely equal to values around 0.5. This indicates

that the two regimes are quite distinct, and that the approach gives a clear indication

which regime prevails.

To compare the identification with that of rules-based methods, we also plot the series

of rounded probabilities. If a bull probability exceeds 0.5, we categorize the observation

as bullish, otherwise as bearish. The RS2-models differ substantially from the LT and PS

models. We do not see a comparable alternation of bull and bear markets, but instead

periods of bull markets that are interrupted by brief bear markets (e.g., 1955–1975 and

1983–1995) and periods of bear markets that are interrupted by brief bull markets (e.g.,

1979–1983 and 1997–2003). The number of cycles is much larger at 34 (RS2C) and 43

(RS2L), and consequently the duration is considerably shorter. Bull markets last on average

52 to 64 weeks; bear markets only 16 to 21 months. Still, the longest bull market still lasts

336 or 337 weeks, and the longest bear market 78 weeks. The impact of time-variation

in the transition probabilities is small, since the RS2C and RS2L-model produce a highly

similar identification.

To see why the rules-based methods and the RS2-models produce such different identi-

fications, we report the means and volatilities of the bullish and bearish regimes in Table 2.

Bull markets have a positive average return and low volatility, whereas bear markets ex-

hibit negative returns and high volatility. When using rules-based methods, the difference

between bull and bear markets is concentrated in the average return, which is about a

full 1% lower when a bear market occurs. The volatility of bear markets is higher, but

the ratio of bear to bull market volatility is around 1.30. Regime switching models pay

more attention to volatility. Consequently we observe the largest difference there. In the

RS2-models, the volatility ratio is around 2.25, while the difference in average returns is

23

only around 0.44%. As a consequence, the RS2-models identify high volatility periods as

bearish, even if prices eventually increase, and low volatility periods as bullish, even if

prices fall. That’s why the periods with gradually falling prices in the 1950s are seen as

bull markets, and why the volatile price increase from 1997 to 2000 is qualified as bearish.

Of course, a risk-averse investor may indeed judge volatile price increases as unattractive.

We consider such a comparison when we calculate the switching fees.

When we allow three regimes in Figures 2(e–f), the identification is between the rules-

based methods and the RS2-models. Compared to the RS2-models, we see more and longer

bear markets in the period 1955-1990, which puts the RS3-models more in line with the

rules-based approaches. Table 2 shows that the bullish regime of the RS3-models has the

same characteristics as the bullish regime in the RS2-models. Instead of one bearish regime,

we now see two: a mild one with an average return just below zero and volatility similar

to the rules-based methods; and a strongly bearish regime with a large negative average

return and very high volatility. The presence of the strongly bearish regime is limited to

a few periods, notably the big declines by the end of 1974, the crash of October 1987, and

the big drops during the credit crisis in 2008.

Table 1 also shows that the RS3-models are closer to the LT and PS-methods than

the RS2-models. They identify 17 bull markets, that last on average 2 years. Again, the

duration shows quite some variation. The RS3C (RS3L) model identifies 24 (25) mild bear

markets and 7 (8) strong bear markets. Mild bear markets last around 45 weeks, whereas

strong bear markets last on average 9–11 weeks, though their maximum is still half a year.

When we aggregate the identification of mildly and strongly bearish regimes, we end up

with 17 bearish periods that last on average 69-72 weeks, which is again quite in line with

the rules-based results.

So far, we compared the identification of the different methods by figures or summary

statistics. Such comparisons cannot be summarized in one number and may be misleading.

Therefore, we calculate the integrated absolute difference (IAD) of Section 3.1, which

compares the identification by two methods on a week-to-week basis. For the models with

three regimes, we aggregate the mildly and strongly bearish regimes, and concentrate on

24

the bullish versus the two bearish regimes. The average IAD for all combinations of two

methods in Table 3 can be interpreted as a probability, so they are bounded between 0

and 1. Of course, a difference of 1 simply means that two method produce completely the

opposite identification. The average difference between the LT and PS-method is small,

only 0.068. We can say that with a probability of only 6.8% the identification by the LT-

and PS-methods differs.

The probability that the rules-based methods produce a different identification than

the regime switching models is much higher, as the IAD’s range from 0.247 to 0.313. Even

though the summary statistics for the RS3-models were close to those for the rules-based

methods, the IADs show that the differences between these models are comparable to the

differences between the RS2-models and the rules-based models. The IADs between the

regime switching models with two or three regimes are smaller, but still indicate a proba-

bility of around 17% of a different identification. Time-varying transition probabilities lead

only to minor changes in the identification, with IADs of 0.032. Because the differences

between constant and time-varying transition probabilities are so small, we postpone a

more detailed comparison to Appendix C. There we also consider conventional techniques

for model comparison.

We use the stationary bootstrap of Politis and Romano (1994) to construct confidence

intervals around the estimated IADs. In this bootstrap, for a given drawing the next

drawing is random with probability p or the next observation with probability 1 − p. Since

bull and bear markets are highly persistent (see Table C.1), we put this probability p at a

low value of 0.05. The confidence intervals are quite wide, which indicates that the methods

can produce quite varying results. They also indicate that the distribution of the IADs is

skewed to the right. No confidence interval includes zero, which implies that all methods

produce significantly different identifications. For the LT and PS-methods, their IAD can

be as large as 0.141. The 90%-confidence intervals also show the distinction between the

rules-based and regime-switching models, with a 5% lower bound on the IADs of around

0.17. Within the class of regime-switching models IADs are simply not very precise.

25

The IAD is a statistical measure of the difference between two methods, but it does not

tell how important this difference is. Therefore, we also look at the fee that an investor

would be willing to pay to switch from one method to another. In Section 3.2 we derive

this fee in an investment setting. Since we consider identification here, this fee corresponds

with a situation of perfect foresight. The investor knows with certainty whether a method

labels the next period as bullish or bearish, instead of having to predict it. So, the results of

this investment setting give an upper bound to what could possibly be reached in real-life.

We report the performance measures and fees in Table 4. The rules-based methods

lead to a stunning average return of 48% per year with a volatility of 30%. So, if an

investor would be able to correctly predict bull and bear markets, this is her expected

performance. The regime-switching models lead to smaller returns, ranging from 7.3% to

9.9% per year, but also to considerably less volatility of around 11%. The difference in

magnitude comes to some extent from the fact that the rules-based identification is binary

(either a bull market or a bear market prevails), while the various regimes switching models

always attribute a non-zero probability to every regime. Still, the Sharpe ratio is twice

as high for the rules-based methods. Utility is four to five times higher. Here we see the

influence of qualifying volatile periods with price increases as bearish and tranquil periods

with price decreases as bullish.

The fees in Table 4b indicate that a risk-averse investor, with a coefficient of relative

risk aversion equal to five, would be willing to pay a considerable fee to switch from the

regime-switching models (columns) to the rules-based methods (rows). For example, she

would pay up to 18.63% per year to switch from the RS2C model to the LT-method,

and 18.77% to switch to the PS-model. We use the same bootstrap as for the IADs to

construct confidence intervals. We find that the fees to switch from the RS2-models to the

rules-based methods differ significantly from zero, so the RS2-models lead to a significantly

inferior identification. Confidence intervals for the fees to switch from the RS3-models to

the rules-based methods are wider, and may even include zero. They indicate that the

outperformance of the RS3-models by the rules-based methods is less precise.

26

An investor would pay a small fee of 1.37–2.14% to switch from the RS3-models to

an RS2-model. However, the 90% confidence intervals are wide, include zero and indicate

that this fee is also often negative. So though we actually observe an underperformance by

the RS3-models, we can just as easily find outperformance. The investor would also pay

a small fee to switch from models with constant transition probabilities to models where

they are time-varying. In case of the RS2-models this fee has small confidence intervals,

which include zero. In case of the RS3-models, the fee is less precise and can vary from

-1.29% to 11.85%. Here the added value of the predicting variables can be a bit larger.

We conclude that the rules-based approaches produce substantially different bull and

bear markets than the regime-switching models. While the rules-based approach tend

to identify relatively long periods of bull and bear markets, the regime-switching models

exhibit periods when bull (bear) markets dominate with short interruptions of bear (bull)

markets. Maheu et al. (2009) explicitly accommodate rallies during bear markets and

corrections during bull markets in their regime switching models. The driving force behind

these differences is volatility, which is important for identification by regime switching but

completely ignored by the rules-based methods.

From an investor’s perspective, identification by rules is definitely preferable. Also in

other economic decisions and analyses where bull and bear market periods are needed,

rules-based methods are best to determine these periods. However, the fees that we calcu-

late correspond with perfect foresight. In the next section, we see which method performs

best, when the label of the next period has to be predicted.

6 Predictions

The state of the stock market being a comprehensive economic indicator, we are more inter-

ested in predicting it than just identifying it. Good predictions can tell investors whether

to expect a good or bad performance of investments. More generally, it signals whether

the economic outlook is good or bad, and whether risk premia are low or high. This means

that we should not only compare the different methods by their ex-post identification,

but mainly by the predictions that they yield. For identification, rules-based methods are

preferable, because they excel in ex-post separating profitable from losing periods. It is

27

not obvious whether this advantage carries over to forecasting. The rules-based methods

indicate only after some time what the sentiment of the stock market is. For example, the

LT-method needs a price increase of 20% to categorize a period as bullish. The PS-method

excludes the last 13 weeks from identification. If it is unknown which state currently pre-

vails, these methods may fail to correctly predict the future state, in particular when a

switch has just occurred. Regime switching models may respond quicker to switches.

To see which method is best in predicting the future state of the stock market, we set

up a prediction experiment. An investor uses the first part of the sample period until June

24, 1983 for identification and the estimation of model parameters, and uses these to make

one-step-ahead predictions for the second part of the sample period. At every point in

time, she updates her information set to construct a prediction for the next week. When

52 weeks have passed, the investor expands the estimation window and reestimates the

parameters of the different models. Given the duration of bull and bear markets, 52 weeks

offers an acceptable trade-off between estimation speed and accuracy. We compare these

predictions in a statistical way, using standard techniques for predictive accuracy and the

Intergrated Absolute Differences. To assess the economic importance of these differences

we compare the performance of investment strategies based on the different methods, and

calculate the maximum fees to exchange one method for another.

The investor applies the methods in the same way as in the previous section. When

she uses the LT or PS-method, she first identifies bull and bear markets in the in-sample

period, and next estimates a Markovian logit model with or without predictive variables.

For the regime-switching models, the investor estimates the parameters over the in-sample

period. When transition probabilities (either in the Markovian logit or the regime switching

models) can be time-varying, the specific-to-general approach is used to select the variables.

This approach implies that the set of selected variables varies over time.

At each point in time t, the investor combines the most recent parameters estimates with

the current information set to predict the state of the market at t + 1. In the LT-method,

she knows the sentiment of the market until the last extremum. If the last extreme price

was at t∗ < t, she will make her first prediction for t∗ +1, and use the recursion in Eq. (2) to

arrive at the prediction for t + 1. In the PS-method, predictions start at t − 13, as switches

in the last 13 weeks are ignored. For the regime-switching models, she applies the filter

28

to infer the state of the market at time t. Multiplying these inference probabilities with

the transition matrix produces the forecast probabilities. Regarding the weekly predicting

variables, the values of time t are used, whereas for monthly variables the values of the

month ending before week t are taken.

We present the predictions of the different methods with and without predictive vari-

ables in Figure 3.7 The black lines shows the probability for a bull market at each point

in time. We compare the predictions with the full-sample identification of the different

methods. In Figure 3a, we see that the predictions of the LT-method without predictive

variables (LTC-method) lag the ex-post identification. It can take quite some weeks before

the LT-method predicts the correct state of the market after a switch. We also see that

the during a bull (bear) market the probability of a continuation gradually declines, until

a new maximum (minimum) is reached and the probability jumps back to one (zero).

Table 5 reports statistics on the quality of the predictions. The LTC-method predicts

79.9% of the bull market weeks correctly, but only 43.6% of the bear market weeks. In total,

the hit rate is 71.1%, which is lower than the hit rate that results from always predicting a

bull market. The Kuipers score, which equals percentage of correctly predicted bull markets

minus the wrongly predicted bear markets, is positive, but not very large. It balances the

percentage of hits with the percentage of false alarms, giving both an equal weight (see

Granger and Pesaran, 2000, for a discussion). We also calculate the IAD between the

predictions and the realizations of a specific method. The IAD from predictions by LTC-

method differ with a probability of 0.194 from the realizations of the LT-method.

Figure 3b shows that the use of predictive variables in the LT-method leads to stronger

swings in the forecast probabilities. Sometimes, switches are sooner predicted, but at

other points in time it takes longer before the LTL-method predicts the correct state of the

7

We present and discuss the evolution of the parameters in Appendix D.

29

market after a switch. As indicated by Table 5, this holds in particular for bear markets,

where the hit rate decreases to 38.4%. The overall hit rate and the Kuipers score are also

lower, compared to the LTC-method. The IAD for the LTL-method is higher than for the

LTC-method, pointing at a larger difference between prediction and realization.

The predictions of the PS-method with constant transition probabilities (PSC) in Fig-

ure 3c look quite different from the LT-predictions. In the PS-method, switch points are

determined by lower bounds on the duration of cycles and phases. A low peak or shallow

trough can be (mis)taken for a switch point as long as the restrictions on duration are

met. Compared to the LT-methods, the PSC-method predicts true switches sooner. The

downside of this method are the frequent false alarms that last a couple of weeks. The

PSC-method scores better at predicting bear markets with a hit rate of 62.6%. For bull-

markets the performance is comparable. The overall performance compares positively with

the LT-methods, as the overall hit rates, the improvement over the default bull strategy

and the Kuipers score are higher, while the IAD is lower. Using predictive variables leads

to better predictions of bull markets, but worse of bear markets. Overall, the accuracy is

slightly less than with constant transition probabilities.

Figure 3e corresponds with the two-state regime switching models with constant transi-

tion probabilities. Here we compare the predictions with the rounded full-sample smoothed

inference probabilities. The RS2C-model is quicker than the rules-based methods in picking

up switches in the state of the market. The hit rate for the bullish state is 92.9%. However,

we also see some false alarms, where the RS2C-model indicate a switch, that is revised one

or two weeks later. This effect is stronger during bear markets than during bull markets.

So, also for the regime switching model, bear markets are more difficult to predict, with

a hit rate of 71.4%. Overall, the hit rate is impressive with 85.7%, an improvement of

19.4% over the “default bull”-strategy. The IAD can be calculated directly from the fore-

cast and the smoothed inference probabilities, without rounding them first to integers. It

indicates an average difference between prediction and realization of 0.158. The addition

of predictive variables only leads to marginal differences.

To compare the forecast probabilities of the RS3-models with the other models, we first

aggregate the probabilities to a bull and a bear probability. The full-sample results in the

previous section showed a single bullish regime (positive mean) and two bearish regimes

30

(negative means), one being mildly and the other strong. Figure D.1(e–f) in Appendix D

actually shows two bullish regimes (mild and strong) before 2009. Therefore, we aggregate

the regimes depending on the sign of their means. The predictions of the RS3-models in

Figure 3(g–h) are good for bull markets (hit rates are 99.6% and 100%), but less accurate

for bear markets (hit rates of 42.2% and 36.8%). During bear markets, predictions oscillate

frequently between bullish and bearish. This is partly caused by the aggregation that we

choose, since regime 2 is only mildly bullish or bearish. Overall, predictions are reasonable,

with hit rates around 70%, which exceed the hit rates of “default bullish” predictions. The

IADs for the RS3-models are considerably higher than those for the RS2 models. We

conclude that the predictions of the RS3 models are less accurate than the predictions of

the RS2-models, because the evolution of the regimes is more stable for the RS2-models.

It is difficult to draw conclusions from the accuracy statistics in Table 5, because the

accuracy for each method is determined with respect to the ex-post identification of that

method. So, while the forecast probabilities of regime switching models may be close to the

full-sample smoothed inference probabilities, this does not necessarily imply that these are

useful predictions of bull and bear markets. Neither can we say whether predictions of, say,

the LT-method with predictive variables are substantially different than the predictions of

the PS-method without predictive variables. Calculating IADs quantifies the difference

between the various predictions. The fees indicate which predictions are more valuable to

a risk-averse investor, balancing the profits of hits of bull and bear markets with the costs

of false alarms.

We report the IAD between the different predictions in Table 6. The average difference

between the predictions of the LT-method and the PS-method is approximately 0.27. This

is a lot larger than the difference between the identification, which was only 0.068 according

to Table 3. Furthermore, the confidence intervals do not overlap. So while using the LT-

method or the PS-method produces largely the same identification, these methods yield

quite different predictions. These differences are due to different ways in which both

methods identify the current regime.

31

The differences between the predictions by rules-based methods and those from the

regime-switching models vary from 0.231 to 0.331. They have the same magnitude as the

differences between their identifications. So, also in terms of predictions, these methods

produce substantially different results. The lower bounds of the confidence intervals also

show that these differences are substantial. Taking both means and volatilities into account

yields not only different identifications but also different predictions.

Using two or three states in regime switching models produces largely similar predic-

tions. When transition probabilities are constant (time-varying), the IAD is 0.090 (0.095).

The confidence intervals are quite narrow. When we compare that to the results in Table 3,

we conclude that the two and three-state regime switching models differ more in their ex

post identification than in their predictions.

Using predictive variables does not change the predictions by much. The largest IAD

with a value of 0.082 is for the difference between the predictions of the PSC and the

PSL-method. The upper bounds on these probabilities confirm that the IADs here are

typically small. We conclude that predictive variables do not help much when predicting

the state of the stock market. Given that the state of the stock market is an important

predictive variable of other economic variables itself, this result is not surprising.

Finally, we evaluate the predictions of the different methods in an investment setting.

In this setting, the investor combines the forecast probabilities with the state-dependent

means and volatilities to construct the optimal portfolio in Eq. (14). The state-dependent

means and volatilities are updated together with all other parameters every 52 weeks.

We plot the cumulative result of this portfolio for each method in Figure 3 (blue lines)

and report the corresponding summary statistics in Table 7a. As a reference, we add the

performance of a strategy that always takes a long position in the stock market, w = 1.

The LTC-method yields the highest return of all methods. It ends up with a cumulative

return of 237% over 27 years, which corresponds 8.73% per year. This yearly return is

considerably less than the 48.1% that would result from 100% correct forecasts. Figure 3a

shows that this difference comes from the lag in identifying switches. Money is lost at the

beginning of bull and bear markets. The performance of the method is similar during bull

and bear markets. The volatility of the strategy remains high at 30.3% per year. The

resulting Sharpe-ratio of 0.27 compares positively to the Sharpe ratio of an investment in

32

the market, which has a return of 3.43% per year, a volatility of 16.7% and a Sharpe ratio

of 0.21. The utility is actually lower than that of the long position of the market, because

of the higher volatility that it yields.

Introducing predictive variables worsens the performance of the LT-method. The pre-

dictive variables lead to a higher return during periods that are ex post identified as bullish,

but produce a loss of 2.69% during bearish periods. As a result, the overall return decreases

from 8.73% to 7.13% per year, with the Sharpe ratio and utility decreasing accordingly.

The Sharpe ratio still exceeds the ratio of the market.

The PS-methods perform considerably worse than the LT-methods. The cumulative

returns are negative for a prolonged period. The lagged response to actual switches and

the many false alarms have a disastrous result on the performance, which is meagre at

1.48% to 2.26% per year. In the PSC-method, the many false alarms particularly hurt

the performance during bull markets which is lowest among all methods. It it the only

strategy that performs better during bear markets than during bull markets. Including

time-variation improves the performance during bull markets, but performance during bear

markets deteriorates. Volatility is comparable to the LT-methods, which results in a low

Sharpe ratio of 0.053–0.075 and lower values for utility, compared to the LT-methods and

the market. The false alarms are less of an issue when predictive variables are used, as the

average return increases from 1.48% to 2.26%. However, volatility increases as well with a

dismal effect on utility.

The RS2-models give the highest utility of all methods. The average returns of these

strategies are rather small, ranging from 0.97 to 1.52%, but volatility (9.5–10.1%) is also

much lower than for the rules-based methods. As a consequence, the Sharpe ratios of

0.10–0.15 exceed those of the PS-methods, though they are still lower than the those

of the market and the LT-methods. The reason for this good performance is the smaller

magnitude of the portfolios that the investor takes when adopting an RS2-model. The small

magnitude is caused by the smaller magnitude of the expected returns in the RS2-models

and the higher volatility of the bearish regime (see Table 2 and Figure D.1). The stronger

focus on volatility of the RS2-model leads to more prudent forecasts and investments.

33

Allowing for time-variation in the transition probabilities improves the performance during

bull markets at the expense of the performance during bear markets. In total, the RS2L-

model outperforms the RS2C-model with a higher Sharpe ratio, and higher utility.

The performance of the RS3-models if Figure3(g–h) is at first better than for the RS2-

models, but reverts after 1997. The RS3C-model yields the lowest average return of all

strategies at 0.34% per year. Though its volatility is also low, the Sharpe ratio remains

lowest for this strategy. In terms of utility, this strategy performs worse than the RS2-

models, but better than the rules-based models and the market strategy. Also here, adding

predictive variables produces better results, since the average return, the Sharpe ratio and

utility for the RS3L-model exceed those for the RS2L-model. However, the performance

of the RS2L-model is even better, indicating that more regimes are not that beneficial for

forecasting.

The fees for exchanging one method for another method in Table 7b are derived in

a utility setting. A higher utility of a strategy corresponds with a higher fee for that

strategy. Since the RS2L-model yields the highest utility, the investor is willing to pay a

fee to adopt this method instead of any other. In particular, she wants to pay a considerable

maximum fee of around 17% per year to change from the rules based methods to it. The

confidence intervals indicate that this amount is significant. The same conclusion applies

to all switches from a rules-based method to a regime-switching model.

The investor does not want to significantly pay for other switches. While the LT-

methods yield higher average returns and utilities than the PS-methods, the confidence

intervals for the fees all contain zero. The magnitude of these fees is also low, with a

maximum of 2.75% per year. The fees to switch between the regime-switching models do

not exceed 2% per year, and are also not significantly different from zero. The investor

actually wants to pay a fee to discard predictive variables in the rules-based methods.

When working with regime-switching models, the investor would pay a small fee for these

variables. However, in both cases the confidence intervals contain zero.

We can draw several conclusions from this analysis. First, regime-switching models

perform best from a utility perspective. Since they take both means and volatilities into

account, they lead to more accurate predictions, less extreme positions and a higher utility.

A risk averse investor is willing to pay a significant fee to use a regime-switching model.

34

This fee mainly represents the lower volatility that results from regime-switching models.

Also for other economic decisions where both the predicted direction and volatility of the

stock market are important, regime switching models are best used.

Second, looking just at average returns, volatilities and Sharpe ratios, the LT-methods

perform best. It produces a higher average return and a better Sharpe ratio than all other

strategies, including a long position in the market. While this method is slow in picking

up switches in the state of market, as indicated by the low hit ratios, its performance does

not suffer much from false alarms.

Third, the predictions from the rules-based methods and the regime switching models

differ considerably. As expected, this difference is obvious for the rules-based methods

on the one hand, and the regime switching models on the other hand. Regime switching

models take both means and volatilities into account, whereas the rules-based method

just look at the trend of the market. However, we find difference between the LT and

PS-methods that are just as large. Similarity in identification does not imply similarity

in predictions. Restrictions on price changes lead to quite different results compared to

restrictions on duration.

Fourth, most strategies perform better during bull markets that during bear markets.

Hit rates are higher during bull markets, and most strategies actually lose money during

bear markets. The rules-based methods are too late spotting the beginning of a bear

market and suffer from false alarms. The regime-switching models classify volatile periods

as bearish, and take short positions. If prices increase, they end up with a loss.

7 Robustness checks

Our results and conclusions may be sensitive to some arbitrary choices that we have made

in our analyses. The rules-based methods require parameters to determine which peaks

and troughs signal switches between bull and bear markets. In the economic comparison

of the different methods, the coefficient of relative risk aversion is a crucial coefficient. In

this section we analyse how our results change when we change these settings.

35

7.1 Thresholds in the LT-method

The LT-method requires an increase in exceedance of λ1 since the last trough for a bull

market to start, and a decrease of more than λ2 for a bear market to begin. The values of

20% and 15% we have used so far have been argued by LT to be most conventional. They

also consider lower threshold combinations of (0.20, 0.10), (0.15, 0.15) and (0.15, 0.10). We

consider these values as well. Lower thresholds may be particularly interesting, because our

results show that the speed with which the current regime is identified is crucial for good

predictions. Lower thresholds make it easier to identify a switch, but may also lead to more

false alarms. We compare the performance of the LT-methods with different thresholds

as in Sections 5 and 6. We discuss the main results here. The full results and a detailed

discussion are available in Appendix E.1.

The full sample results on identification show that lower thresholds leads to more cycles,

in particular when both thresholds are lowered. However, the IADs between the different

identifications indicate that they differ in less than 5% of the weeks. The choice of thresh-

olds does not much affect the pattern of bull and bear markets in Figure 2a. Even though

the changes are statistically small, the economic comparison indicates that they present

improvements. The fees that an investor is willing to pay to switch to identification with

(0.15, 0.10)-thresholds are positive and significant. These results strengthen our conclusion

that the LT-method works better for identification than the regime-switching methods.

For predictions the results are more mixed. We find that the predictive accuracy in-

creases for lower thresholds, in particular for bear markets. The hit rates and Kuipers score

of the (0.15, 0.10)-thresholds come close to the results for the two-state regime switching

models. The IADs between the predictions of the LT-methods with different thresholds

indicate a different prediction for 7–16% of the weeks. While larger than the differences

for identification, they are smaller than the differences between the different methods in

Table 6. The improvements in predictive accuracy are not fully matched by economic

improvements. Lower thresholds lead to investments that produce higher average returns,

but also higher volatilities. Sharpe ratios still increase, but utility is sometimes lower.

Only a lower threshold for λ2 of 0.10 leads to an increase in utility and positive,though

insignificant, fees. The utility of the (0.20, 0.10)-thresholds is still substantially lower than

36

the utility for the RS2-models in Table 7. We conclude that lower thresholds bring the

statistical quality of the predictions at the same level as the regime-switching models, but

do not improve the economic quality enough to beat them.

The PS-method use minimum constraints on the length of cycles and phases to select the

peaks and troughs that indicates switches between bull and bear markets, and censors a set

of first and last observations. The settings for these constraints are based on the algorithm

of Bry and Boschan (1971) for business cycle identification and common market lore. As PS

do not consider robustness checks themselves, we consider some changes in the parameters

based on our results so far. The LT-method performs better with relaxed restrictions, so

we mainly investigate relaxations. We consider a lower minimum on cycle duration of 52

weeks (instead of 70 weeks). For the minimum on phase duration we consider 12 and 20

weeks (standard at 16 weeks). We relax the minimum price change to overrule the phase

constraint to 15%. We also investigate the consequences of censoring more (26 weeks) and

less (7 weeks). We discuss the main results here. For the full results and a discussion, we

refer to Appendix E.2.

For identification, changes are negligible. Identification does not change at all when we

change the constraints on phase duration or price change. Censoring 7 weeks leads to an

extra bear market at the end of the sample period, but censoring 26 weeks has no effect.

Lowering the cycle constraint to 52 weeks leads to one extra cycle. Together, it means

that the conclusion that the PS-method works well for identification is robust to these

parameter changes.

Neither does a relaxation of the constraints on minimum length or minimum price

change largely impact predictions. The overall predictive accuracy stays the same, do we

sometimes see accuracy improvements for bull markets at the expense of bear markets. The

IAD between the predictions for different settings and the predictions produced by the basic

setting are not significantly different from zero. The fees for switching are economically

small and insignificant.

Censoring shows a larger impact, in particular for the economic difference measures.

37

Predictive accuracy is largely unaffected by censoring more or less data. However, the

IADs between the predictions of the standard approach and approaches with more and

less sensoring are quite substantial. The economic comparison shows that more censoring

leads to less extreme portfolio weights, higher means, lower volatilities, higher Sharpe

ratios and higher utility, while censoring less has the opposite effect. These effects can all

be explained by the effect that censoring has on a prediction. When more observations at

the end are censored, an investor essentially makes a forecast for a longer horizon, applying

a longer recursion of Eq. (2). If the prediction horizon rises, the prediction converges to

the long-term average (see e.g., Table C.1b) and typically become less extreme. When

predictive accuracy is determined, predictions are rounded, so shrinkage to a long-term

average does not matter. To the contrary, less extreme predictions lead to less extreme

investments, and to a better performance. When 26 weeks are censored, utility is close to

the utility of long position in the market and only slightly below the utility of the two-state

regime switching models.

Overall, we find that our conclusions are robust to changes in the design of the PS-

method. Constraints on the duration of cycles or phases or on price changes only have a

small effect. The effects for censoring show that rules-based methods rely too much on the

past direction of the market when making predictions. Paying more attention to volatility

as regime switching models do leads to better performance. Shrinking predictions towards

their long-term average also leads to less extreme investments and a better performance.

The economic measure for comparison that we propose in Section 3.2 depends on the

coefficient of relative risk aversion γ. Throughout our analysis so far, we have set γ = 5,

which is conservative though still in the generally accepted range for this parameter. In

this subsection we show how sensitive our results are to the choice for γ.

The optimal portfolio w m in Eq. (14) is proportional to the inverse of γ. This relation

caries over to the expected return of an investment strategy, which is proportional to 1/γ

as well, and the variance which is proportional to 1/γ 2 . Consequently, both effects of risk-

aversion exactly cancel out in the Sharpe ratio. The expected utility being the sum of the

38

expected return and the second moment weighted by −γ/2 is also inversely related to γ,

" m 2 #

m

1 µ 1 µ

V (w m ) = EGr w m r − γ(w m r)2 = EGr r − γ r

2 γψ m 2 γψ m

" 2 # (21)

1 µm 1 µm

= EGr r− r .

γ ψm 2 ψm

Finally, the switching fee is proportional to 1/γ. To derive this result, we make the effect

of γ in Eq. (18) explicit, where we use V (µm /ψ m ) for the expected utility for γ = 1

corresponding with model m

m n m

1 µ µ µt 1 2

V − V − 1 − EG r t+1 ηm,n − γη =0 (22)

γ ψm ψn r m

ψt 2 m,n

Solving for ηm,n produces

m

1 µt

ηm,n = − 1 − EGr rt+1 ±

γ ψtm

s

m 2 m n (23)

µt µ µ

1 − E Gr r

m t+1

+2 V − V

ψt ψm ψn

Tables 4a and 7a. Means, volatilities, utilities and switching will all decrease (increase)

by the same relative amount. However, the ordening of the strategies will not be affected

and our conclusions regarding the preferred method are robust. The confidence intervals

around the fees are also proportional to 1/γ, as the proportionality of the switching fee

applies similarly to simulated fees. So, fees that are significantly different from zero remain

significant independent of the choice of γ.

8 Conclusion

In this article we compare the identification and prediction of bull and bear markets by

four different methods. One way to address identification and prediction is by formulating

rules to determine bullish and bearish periods, and then as a second step use binary models

for prediction. In this category, we consider the approaches of Lunde and Timmermann

39

(2004) and Pagan and Sossounov (2003). Both base identification on peaks and troughs in

price data. To find switch points Pagan and Sossounov (2003) impose restrictions on the

length of cycles and phases, whereas Lunde and Timmermann (2004) impose restrictions

on price changes. As an alternative, an investor can formulate a model that simultaneously

handles identification and prediction. We consider a simple regime switching model with

a bull and a bear state, and an extended version that includes three states. We apply the

different methods to the S&P 500.

To deal with the latent nature of bull and bear markets, we propose two new measures

to compare the identifications and predictions of the various methods. The Integrated

Absolute Distance is a generally applicable statistic quantifying the difference between the

inferred or predicted probability of regimes. The switching fee quantifies the preference for

one method over another from the perspective of a risk averse investor who wants to time

the market.

From the identification we conclude that the rules based approaches produce more or

less the same results. A market that has exhibited price decreases since the last peak is

bearish; price increases after the last trough qualify as bullish. To the contrary, the regime

switching models also pay attention to volatility. Periods with an attractive risk-return

trade-off, meaning positive average returns and low volatility, are bullish, while negative

average returns and high volatility are qualified as bearish. Since periods with low volatility

but price decreases can be identified as bull markets, and volatile price increases as bearish,

rules-based methods are preferable ex post. Their identification is significantly different

from the identification by regime-switching models, and is worth a significant fee.

Our results for predictions show that paying attention to expected returns and volatil-

ity is preferable ex ante. Regime-switching models are able to react quicker to bull-bear

switches than the rules-based methods, and they lead to more prudent investments. Be-

cause they yield the highest utility, a risk-averse investor is willing to pay a significant fee

of around 16% to switch from rules-based methods to regime-switching models. Looking

at Sharpe ratios, the method by Lunde and Timmermann (2004) outperforms the other

methods and a long position in the US stock markets. The PS-method performs less, as it

produces many false alarms.

In line with the somewhat depressing results on return predictability in Welch and

40

Goyal (2008), we also find that the inclusion of predictive variables is limited and subject

to changes. For the rules-based approaches, the effect is clearly detrimental, with per-

formance uniformly worse. For the regime switching models we observe improvements in

performance, but the variables that are selected for predictions and their coefficients vary

considerably over our sample period. Overall, the IAD’s between models with and without

predictive variables are small, and fees are negligible.

Harding and Pagan (2003a,b) and Hamilton (2003) have already discussed the differ-

ence between rules-based and model-based approaches, applied to dating business cycles.

As the resulting identifications were largely similar, the main differences were the larger

transparency for the rules-based approaches versus the deeper insight into the data gen-

erating process for the regime switching models. For financial time series, differences are

larger where the rules-based approaches purely reflect the tendency of the market, while

the regime switching models reflect the risk-return trade-off. For applications that require

an ex post series of bull and bear markets, rules-based methods are preferable. If the

state of the stock market is needed in a predictive setting, regime-switching model are best

used.

41

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46

Figure 1: Performance US Market

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This figure show the weekly observations of the US stock market in excess of the risk-free rate over the

period January 7, 1955 until July 2, 2010 (1/7/1955 = 100). The excess stock market index is calculates

as the ratio Pt /Bt , where Pt is the value of the stock market index and Bt is the cumulation of a riskless

Qt−1

bank account, Bt ≡ τ =0 (1 + rτf ). For the stock market index, we use the S&P500. The risk-free rates is

the three-month T-Bill rate. Data have been taken from FRED at the Federal Reserve Bank of St. Louis

and Schwert (1990).

47

Figure 2: Identification of Bull and Bear Markets

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This figure shows the identification of bull and bear periods for the US, based on the different approaches.

The thick blue line plots the excess stock market index (left y-axis). In panel (a), bull and bear markets

are identified by the LT-algorithm, and in panel (b) by the PS-algorithm. Panels (c–d) and (e–f) reflect

identification by two-state and three-state regime switching models, respectively. These models can have

constant or time-varying transition probabilities (panels c and e, and panels d and f, respectively). A think

black line indicates the smoothed inference probability of a bull market (right y-axis). Bullish (bearish)

regimes are indicated with white (pink) areas. A bull (bear) market prevails in the RS-models, when the

smoothed inference probability for regime 1 (2) exceeds 0.5. The strong bear regime prevails when the

smoothed inference probability for regime 3 exceeds 0.5, and is indicated in purple (only for panels e–f).

48

Figure continues on next page.

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Figure 3: Predictions and performance – continued

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This figure shows for each method the predictions and the evolution of the investment performance over

time. The first prediction is made for July 1, 1983 and the last for July 2, 2010, giving a total of 1410

predictions. To make a prediction for week t+1, the LT-method follows the recursion in Eq. (2) from the last

extremum onwards. The PS-method starts this recursion 13 weeks prior to week t. The regime-switching

models apply the standard filter technique with the last available model parameters. All approaches use

weekly explanatory variables up to week t and monthly explanatory variables up to the last month prior to

week t. The parameters in the Markovian logit models for predictions in the rules-based approaches, the

state-dependent mean µm m

s and second moment ψs , and the parameters of the regime switching models are

updated every 52 weeks. We plot the predicted probability of a bull market with a black line (secondary

y-axis). For the RS3-models, we calculate the probability of a bull market as the sum of the predictions

for regimes with positive means. The pink areas indicate the periods of bear markets as identified based

on the full sample as in Figure 2. The asset allocation for method m at time t equals wtm = µm m

t /(γψt ),

m m

with risk aversion parameter γ = 5. The values for the mean µt+1 and second moment ψt are calculated

as in Eqs. (15) and (16). The blue line shows the cumulative result (in %) of this portfolio.

50

Table 1: Number and Duration of Market Regimes

approach LT PS RS2C RS2L RS3C RS3C∗ RS3L RS3L∗

bull number 16 19 34 43 17 17 17 17

avg. duration 119 95 64 52 102 102 98 98

med. duration 90 74 24 23 64 64 62 62

std. dev. duration 97 61 77 90 90 90 91 91

max. duration 405 276 336 337 314 314 313 313

min. duration 15 27 2 2 13 13 5 5

avg. duration 62 61 21 16 45 69 46 72

med. duration 60 60 12 10 41 42 41 42

std. dev. duration 44 30 17 23 23 66 32 79

max. duration 187 132 78 78 91 261 163 327

min. duration 7 15 1 1 8 8 5 9

avg. duration 11 9

med. duration 8 3

std. dev. duration 10 12

max. duration 28 29

min. duration 1 2

This table shows for every method the number of spells of the different market regimes, their average

and median duration, the standard deviation of the duration, and its maximum and minimum. For the

two-state regime switching models, a period is qualified as bullish if the smoothed inference probability for

the bull regime exceeds 0.5 and bearish otherwise. For the three-state regime switching models, the highest

smoothed inference probability determines the prevailing regime. In the columns RS3C∗ and RS3L∗ , the

mildly and strongly bear markets have been aggregated.

51

Table 2: Return Characteristics of Bull and Bear Markets

regime LT PS RS2C RS2L RS3C RS3L

bull mean 0.38 (0.04) 0.40 (0.04) 0.16 (0.04) 0.16 (0.04) 0.15 (0.04) 0.16 (0.04)

vol. 1.82 (0.06) 1.86 (0.07) 1.47 (0.04) 1.47 (0.04) 1.38 (0.04) 1.39 (0.04)

(mild) bear mean −0.60 (0.08) −0.54 (0.07) −0.27 (0.13) −0.30 (0.14) −0.04 (0.08) −0.06 (0.08)

vol. 2.46 (0.16) 2.36 (0.15) 3.28 (0.24) 3.34 (0.25) 2.43 (0.16) 2.36 (0.15)

strong bear mean −0.95 (0.73) −0.74 (0.62)

52

This table shows the mean and the volatility (in % per week) for the different regimes under the different approaches. In the approach of LT

and PS identification is based on peaks and troughs in the prices series. Conditioning on the regimes, we estimate the means and volatilities

of the returns distributions. In the regime switching approach, we estimate the model for the return distributions with two regimes (bull and

bear, columns RS2C and RS2L) and with three regimes (bull, mild bear, and strong bear, columns RS4C and RS4L). We report standard

errors in parentheses. For the LT- and PS-methods we calculate HAC consistent standard errors of Newey and West (1987) in a GMM setting.

For the regime switching models, we use the Fisher information matrix to compute standard errors.

Table 3: Integrated Absolute Differences of Identification

PS RS2C RS2L RS3C RS3L

LT 0.068 0.247 0.234 0.268 0.272

[0.034, 0.141] [0.187, 0.355] [0.171, 0.355] [0.201, 0.454] [0.200, 0.505]

PS 0.291 0.277 0.311 0.313

[0.220, 0.365] [0.214, 0.368] [0.220, 0.483] [0.214, 0.486]

RS2C 0.032 0.154 0.167

[0.015, 0.061] [0.088, 0.555] [0.084, 0.602]

RS2L 0.168 0.182

[0.098, 0.564] [0.081, 0.591]

RS3C 0.032

[0.022, 0.271]

This table reports the integrated absolute distance between the identification of the different approaches,

based on two states. For the difference between the LT- and PS-method, and the RS2-models we use

Eq. (10). For comparisons between the LT- and PS-method on the one hand and the RS-models on the

other hand, we incorporate Eq. (11) into the calculation. When the RS3-models are part of the comparison,

we aggregate the mild and strong bear regimes. We report the 5% and 95% percentiles between brackets for

each statistic based on the 200 bootstraps of both the return and the explanatory variable series following

Politis and Romano (1994).

53

Table 4: Performance Measures and Fees Based on Full-sample Identification

(a) Performance Measures

LT PS RS2C RS2L RS3C RS3L

Mean 48.1 48.4 9.4 9.9 7.3 8.0

Volatility 30.3 30.4 11.3 11.3 10.6 11.3

Sharpe ratio 1.59 1.59 0.83 0.87 0.69 0.71

Utility 0.241 0.242 0.061 0.066 0.045 0.048

(b) Fees

LT PS RS2C RS2L RS3C RS3L

LT 0 -0.13 18.63 18.10 20.29 20.03

[-5.37, 4.94] [10.30, 24.08] [9.86, 24.02] [2.93, 22.65] [-2.25, 22.38]

PS 0.13 0 18.77 18.24 20.42 20.16

[-4.92, 5.40] [10.36, 24.02] [10.05, 23.34] [2.67, 21.82] [0.34, 21.49]

RS2C -18.26 -18.39 0 -0.52 1.62 1.37

54

[-23.45, -10.15] [-23.45, -10.20] [-1.96, 1.07] [-12.57, 2.34] [-17.11, 2.17]

RS2L -17.74 -17.87 0.52 0 2.14 1.89

[-23.44, -9.71] [-22.80, -9.85] [-1.07, 1.96] [-12.02, 2.58] [-16.97, 1.90]

RS3C -19.88 -20.01 -1.62 -2.14 0 -0.25

[-22.13, -2.88] [-21.32, -2.64] [-2.35, 12.62] [-2.58, 12.06] [-11.80, 1.29]

RS3L -19.63 -19.76 -1.37 -1.89 0.25 0

[-21.91, 2.21] [-21.01, -0.34] [-2.17, 17.17] [-1.90, 17.03] [-1.29, 11.85]

This table reports performance measures of investment strategies that use the different methods as input for an asset allocation and the fees

an agent would be willing to pay to exchange two methods. The asset allocation for method m at time t equals wtm = µm m

t /(γψt ), with risk

m m

aversion parameter γ = 5. The values for the mean µt+1 and second moment ψt are calculated as in Eqs. (15) and (16). The state-dependent

mean µm m

s and second moment ψs are based on the full-sample and reported in Table 2. The state-dependent probabilities are taken as the

identification at time t, which are binary for the rules-based methods and smoothed inference probabilities for the regime-switching approaches.

Based on the realized returns of the asset allocations, we calculate the mean and volatility (in % per year), the yearly Sharpe ratio, and the

annualized realized utility as in Eq. (13). The fee ηm,n to switch from strategy m (in rows) to strategy n (in columns) solves Eq. (18). We

express the fees in % per year. We report the 5% and 95% percentiles between brackets for each statistic based on the 200 bootstraps of both

the return and the explanatory variable series following Politis and Romano (1994).

Table 5: Predictive Accuracy

LTC LTL PSC PSL RS2C RS2L RS3C RS3L

bull correct 852 851 768 779 868 935 708 681

bull wrong 214 215 193 182 66 65 3 0

% bull correct 79.9% 79.8% 79.9% 81.1% 92.9% 93.5% 99.6% 100.0%

bear correct 150 132 281 261 340 269 295 268

bear wrong 194 212 168 188 136 141 404 461

% bear correct 43.6% 38.4% 62.6% 58.1% 71.4% 65.6% 42.2% 36.8%

total correct 1002 983 1049 1040 1208 1204 1003 949

total false 408 427 361 370 202 206 407 461

% correct 71.1% 69.7% 74.4% 73.8% 85.7% 85.4% 71.1% 67.3%

default bull 75.6% 75.6% 68.2% 68.2% 66.2% 70.9% 50.4% 48.3%

improvement -4.5% -5.9% 6.2% 5.6% 19.4% 14.5% 20.7% 19.0%

Kuipers Score 23.5% 18.2% 42.5% 39.2% 64.4% 59.1% 41.8% 36.8%

IAD 0.194 0.222 0.177 0.197 0.158 0.157 0.283 0.318

This table shows the predictive accuracy of the different methods. The predictions are constructed as in

Figure 3. The predicted probabilities are rounded, and compared with the identification that results from

the full sample. For the regime switching models the resulting smoothed inference probabilities are rounded,

too. “Bull (bear) correct” gives the number of true bullish (bearish) weeks that were correctly predicted.

“Bull (bear) wrong” gives the number of true bullish (bearish) weeks that were wrongly predicted. The

percentages are calculated with respect to the number of true bullish (bearish) weeks. The row “default

bull” reports the percentage of total correct predictions, when the models would always predict a bullish

week. The row “improvement” shows by how much a method’s percentage of correct predictions exceeds

the “default bull” prediction. The Kuipers Score is calculated as the percentage of correctly predicted bull

markets minus the percentage of incorrectly predicted bear markets. The row IAD reports the Integrated

Absolute Distance between the predictions and the realizations. We apply Eq. (10) to calculate the IAD

for the rules-based methods, since their predictions are probabilities, while their realizations are binary.

For the RS3-models, we calculate the probability of a bull market as the sum of the predictions for regimes

with positive means.

55

Table 6: Integrated Absolute Differences of Predictions

LTL PSC PSL RS2C RS2L RS3C RS3L

LTC 0.060 0.250 0.276 0.239 0.213 0.239 0.228

[0.057, 0.110] [0.210, 0.288] [0.271, 0.367] [0.203, 0.356] [0.193, 0.332] [0.189, 0.338] [0.178, 0.324]

LTL 0.279 0.275 0.272 0.244 0.269 0.255

[0.216, 0.303] [0.237, 0.345] [0.223, 0.374] [0.212, 0.360] [0.201, 0.364] [0.194, 0.352]

PSC 0.082 0.284 0.262 0.284 0.281

[0.060, 0.145] [0.253, 0.332] [0.236, 0.320] [0.239, 0.332] [0.230, 0.328]

PSL 0.331 0.305 0.327 0.318

[0.294, 0.386] [0.282, 0.379] [0.278, 0.384] [0.276, 0.374]

56

[0.048, 0.077] [0.059, 0.103] [0.074, 0.126]

RS2L 0.086 0.095

[0.072, 0.114] [0.071, 0.118]

RS3C 0.034

[0.029, 0.054]

This table reports the integrated absolute distance between the predictions of the different approaches, based on two states. The predictions

are constructed as in Figure 3. For the difference between all two-state methods we apply Eq. (10). When the RS3-models are part of the

comparison, we concentrate on the predictions of bullish regimes. We calculate the probability of a bull market as the sum of the predictions

for regimes with positive means. We report the 5% and 95% percentiles between brackets for each statistic based on the 200 bootstraps of both

the return and the explanatory variable series following Politis and Romano (1994).

Table 7: Performance Measures and Fees Based on Prediction

(a) Performance Measures

market LTC LTL PSC PSL RS2C RS2L RS3C RS3L

Av. Abs. Weight - 1.82 1.90 1.70 1.87 0.62 0.66 0.61 0.64

Mean 3.44 8.73 7.13 1.48 2.26 0.97 1.52 0.34 1.17

Mean Bull - 8.96 10.30 0.97 5.61 3.62 4.63 4.34 6.66

Mean Bear - 8.01 -2.69 2.56 -4.91 -4.24 -5.50 -3.74 -3.96

Volatility 16.7 32.4 31.9 28.0 30.1 9.5 10.1 10.8 10.9

Sharpe Ratio 0.21 0.27 0.22 0.05 0.08 0.10 0.15 0.03 0.11

Utility -0.036 -0.176 -0.184 -0.181 -0.203 -0.013 -0.010 -0.026 -0.018

(b) Fees

LTC LTL PSC PSL RS2C RS2L RS3C RS3L

LTC 0 0.82 0.50 2.75 -16.60 -16.86 -15.27 -16.06

[-5.18, 1.86] [-7.82, 8.19] [-8.62, 9.64] [-25.66, -8.53] [-26.28, -8.87] [-24.60, -7.67] [-25.71, -7.18]

LTL -0.81 0 -0.32 1.94 -17.40 -17.67 -16.07 -16.86

[-1.86, 5.17] [-6.15, 12.39] [-6.82, 11.50] [-23.32, -6.64] [-24.04, -7.42] [-22.59, -5.69] [-23.28, -5.53]

57

[-8.15, 7.77] [-12.37, 6.12] [-5.69, 6.12] [-26.38, -8.33] [-26.30, -9.44] [-25.12, -8.09] [-25.05, -8.05]

PSL -2.74 -1.93 -2.25 0 -19.28 -19.55 -17.96 -18.75

[-9.56, 8.54] [-11.50, 6.80] [-6.14, 5.68] [-26.11, -8.97] [-27.11, -10.32] [-25.73, -8.02] [-25.90, -8.92]

RS2C 16.21 17.01 16.70 18.90 0 -0.26 1.29 0.52

[8.34, 24.91] [6.51, 22.76] [8.23, 25.86] [8.84, 25.48] [-1.82, 0.64] [-1.15, 2.44] [-1.68, 2.96]

RS2L 16.48 17.28 16.97 19.17 0.26 0 1.56 0.78

[8.70, 25.36] [7.30, 23.42] [9.30, 25.87] [10.13, 26.68] [-0.64, 1.82] [-0.98, 3.36] [-1.43, 3.35]

RS3C 14.93 15.73 15.42 17.62 -1.30 -1.56 0 -0.77

[7.51, 23.85] [5.60, 21.93] [8.02, 24.74] [7.88, 25.10] [-2.44, 1.15] [-3.36, 0.98] [-1.82, 2.26]

RS3L 15.70 16.50 16.19 18.39 -0.52 -0.78 0.77 0

[7.07, 24.94] [5.45, 22.78] [7.92, 24.51] [8.80, 25.35] [-2.97, 1.68] [-3.37, 1.43] [-2.26, 1.82]

This table reports performance measures of investment strategies that use the different methods as input for an asset allocation and the fees an

agent would be willing to pay to exchange two methods. The optimal portfolio is constructed similarly as for Figure 3. Based on the realized

returns of the asset allocations, we calculate the mean and volatility (in % per year), the yearly Sharpe ratio, and the annualized realized

utility as in Eq. (13). Mean Bull (Mean Bear) is the annualized mean during the subperiods identified ex post as bull (bear) markets. For the

purpose of comparison, we report the statistics of a long position in the market. The fee ηm,n to switch to strategy m (in rows) from strategy

n (in columns) solves Eq. (18). We express the fees in % per year. We report the 5% and 95% percentiles between brackets for each statistic

based on the 200 bootstraps of both the return and the explanatory variable series following Politis and Romano (1994).

A Multinomial logit transitions

In Section 2.2 we propose a regime switching model with time-varying transition proba-

bilities. The probability of a transition from regime q to regime s at time t is linked to

predicting variables zt−1 by a multinomial logit transformation

′

eβsq zt−1

πsq,t ≡ πsq (zt−1 ) ≡ Pr[St = s|St−1 = q, zt−1 ] = P βςq ′ zt−1

, s, q ∈ S, (24)

ς∈S e

for notational convenience.

A.1 Estimation

To estimate the parameters βsq , we extend the approach of Diebold et al. (1994), based

on the EM-algorithm by Dempster et al. (1977). Diebold et al. (1994) consider estimation

when the transition probabilities are linked via a standard (binomial) logit transforma-

tion. We maintain the attractive feature of the EM-algorithm that the expectation of the

complete-data log likelihood can be split in terms related to only a subset of the parameter

space. Therefore, we can focus on the part of the log likelihood function related to the

parameters βsq . The transition part of the expectation of the likelihood function is given

by

X

T XX

ℓ(B) = ξsq,t log πsq,t , (25)

t=1 s∈S q∈S

where B = {βsq : s, q ∈ S} is the set of all parameters βsq and ξsq,t ≡ Pr[St = s|St−1 =

q, ΩT ] is a smoothed inference probability. These probabilities are based on the complete

data set of returns and predictive variables ΩT , and are calculated with the method of Kim

(1994).

In the expectation step the set of smoothed inference probabilities is determined. In

the maximization step new parameters values are calculated that maximize the likelihood

function. We derive the first order conditions that apply to βsq by differentiating Eq. (25)

∂ℓ(B) X X

T

1 ∂πςq

= ξςq,t .

∂βsq t=1 ς∈S

πςq ∂β sq

58

Based on Eq. (24) we find

πsq (1 − πsq )zt−1

∂πςq if ς = s

= .

∂βsq −πςq πsq zt−1 if ς 6= s

Combining these two expressions yields the first order condition

X

T

(ξsq,t − ξq,t−1 πsq,t ) zt−1 = 0 ∀q, s ∈ S (26)

t=1

where ξq,t = Pr[St = q|ΩT ]. For each departure state q the set of the first order conditions

for the different s ∈ S comprise a system that determines the set Bq = {βsq : s ∈ S}.

Numerical techniques can be used to find parameters βsq that solve this system.

Because the multinomial logit transformation is non-linear, the coefficients on the explana-

tory variables cannot be interpreted in a straightforward way. To solve this problem, we

calculate the marginal effect of the change in one variable zi , evaluated at specific values

for all variables z̄. The marginal effect is given by the first derivative of (5) with respect

to zi :

!

∂πsq (z) X

= πsq (z̄) βsqi − πςq (z̄)βςqi , (27)

∂zi z=z̄ ς∈S

where βsqi denotes the coefficient on zi . It is easy to verify that the sum of this expression

over the destination states s is equal to zero. Since the probabilities for the destination

states should add up to one, a marginal increase in one probability should be accompanied

by decreases in the other probabilities. When only two regimes are available, the above

expression reduces to the familiar expression for marginal effects in logit models, πsq (z̄)(1−

πsq (z̄))βsqi .

B Predictive variables

The predictive variables that we use in this study are based on data from the Federal

Reserve Bank of St. Louis available via FRED8, except the unemployment rate and the

8

See https://research.stlouisfed.org/fred2/

59

dividend-to-price ratio. For each predictive variable we test whether it has a unit root. If

so, we transform the data to create a stationary time series. The results are reported in

Table B.1, together with the mean and standard deviation of the (transformed) series.

We construct the inflation rate as the monthly relative change in the seasonally adjusted

consumer price index (All Urban Consumers All Items, Series ID: CPIAUCSL). We reject

a unit for the inflation rate at conventional confidence levels, and find an average inflation

rate of 3.78% per year with a standard deviation 1.10%. We construct the growth rate

of industrial production as the yearly relative change in industrial production (seasonally

adjusted, Series INDPRO). It does not show evidence of a unit root, and has an average

of 3.06% with a standard deviation of 5.27%. We obtain the unemployment rate from the

Bureau of Labor Stastics (seasonally adjusted, Series ID: LNS14000000). Because of the

high AR(1)-coefficient and the p-value for the ADF-statistic close to 0.05, we transform

the series by taking a yearly change. The yearly change in unemployment is close to zero

with a standard deviation of 1.14%. These three variables are constructed at the monthly

frequency.

The T-Bill rate corresponds with a maturity of three months and is again taken from

FRED (Series ID: WTB3MS). Because a unit root is not rejected, we transform this series

by taking the difference with respect to the yearly moving average as in Campbell (1991);

Rapach et al. (2005). The resulting difference is on average zero and shows a standard

deviation of 1.04%. We construct the term spread as the yield on a 10-year government

bond (constant maturity, Series ID: WGS10YR) minus the 3-month T-Bill rate. A weekly

series for the 1-year yield becomes available from 1962 onwards. The AR(1)-coefficient

and ADF-test are based on this smaller subsample. They indicate stationarity, so we do

not transform this series. We use the monthly series for the 10-year government bond

and 3-month T-Bill rate to construct the observations from 1955 to 1962, and assume

that the difference stays constant within a month. The average term spread is 1.42%

with a volatility of 1.23%. We determine the credit spread as the difference between the

yield on BAA-rated and AAA-rated corporate bonds (as calculated by Moody’s, seasonally

adjusted). As weekly data become available starting in 1962 again, we follow the same

60

procedure as for the term spread. We reject the null-hypothesis of a unit root for the

subsample with weekly data, and find an average spread of 0.99% and a volatility of 0.46%

for the whole sample.

The dividend-to-price ratio is constructed from several series. We use the dividends se-

ries for the S&P500 as in Shiller (2000), which are available on Robert Shiller’s homepage.9

The series consists of monthly observations of the moving total dividends over the past

twelve months. The price index for the S&P500 is spliced together from Schwert (1990)

and FRED, as explained in Section 4. To calculate the D/P-ratio for time t (in weeks),

we divide the dividends over the last 12 months prior to the month corresponding with

time t by the current price level. As the resulting series shows evidence of a unit root, we

take again the difference with respect to the moving yearly average. This difference is on

average zero and has a volatility of 0.34%.

9

See http://www.econ.yale.edu/~shiller/data.htm for more information.

61

Table B.1: Characteristics of Predicting Variables

Frequency AR(1) ADF p-value Transformation Mean Std. Dev.

Inflation monthly 0.623 -3.26 0.017 3.78 1.10

Ind. Prod., yearly growth rate monthly 0.966 -5.20 < 0.001 3.06 5.27

Unemployment monthly 0.997 -3.05 0.031 yearly change 0.08 1.14

Tbill rate weekly 0.998 -2.36 0.152 change to yearly average -0.01 1.04

Term spread weekly 0.991 -4.28 < 0.001 1.42 1.23

Credit spread weekly 0.993 -3.81 0.003 0.99 0.46

62

D/P ratio weekly 0.998 -1.78 0.390 change to yearly average -0.02 0.34

This table shows the set of predicting variables with its source and frequency. For each variable we conduct an adjusted Dickey-Fuller test.

We report the first order autocorrelation coefficient, the ADF test-statistic and the p-value for the hypothesis of the presence of a unit root. If

this hypothesis is not rejected, the next column shows the transformation that is applied to the variable. The last two columns show the mean

and standard deviation of the (transformed) variables in %. The monthly series run from December 1954 to May 2010; the weekly series from

January 7, 1955 until June 25, 2010. All data series except the D/P ratio are obtained from the Federal Reserve Bank of St. Louis via FRED.

To construct the D/P ratio, we have taken the dividend series from Shiller (2000) and spliced the prices series for the S&P500 together from

Schwert (1990) (up to January 4, 1957) and again from FRED (from that date onwards). The dividend series, which is a twelve month moving

total, is then divided by the price series.

C Additional Results on Identification

The results in Section 5 indicate that the difference between constant and time-varying

transition probabilities in the regime switching models are minor. Here we investigate in

more detail how different the results are.

Table C.1 reports the transition probabilities under the assumption that they are con-

stant over time. Bull and bear markets are quite persistent with probabilities of around 0.95

or higher that the current state prevails for another week. Bull markets tend to be slightly

more persistent than bear markets. Only the strongly bearish regime of is somewhat less

persistent, though its probability of continuation for another week is still 0.89.

dicting variables, which makes them time-varying. In the rules-based approaches, we first

use the LT- or PS-algorithm to label periods as bullish or bearish. We then use these

labeled periods as input for the estimation of the Markovian logit model in (6). The two-

state regime switching model uses the same logistic transformation to link the transition

probabilities to predicting variables. For the four-state regime switching model, the lo-

gistic transformation is extended to the multinomial logistic transformation in (5). We

determine the variables to include for specific departure-destination combinations by the

specific-to-general procedure proposed in Section 4.3. We use a significance level for the

likelihood ratio test of 10%.

According to Table C.2, time-variation can be related to a few economic variables. The

D/P ratio is selected for all models. A rise in the D/P-ratio increases the likelihood of

a bull market in the next period in the LT, PS and RS3L-models. This results comes

as no surprise, since an increase in the D/P ratio can point at higher future expected

returns. In the RS2L-model the D/P-ratio decreases the likelihood of a bull market, which

is more puzzling. It is similarly puzzling than an increase in the D/P-ratio strengthens the

persistence of the strongly bearish regime in the RS3L-model.

63

A rise in the inflation rate negatively affects the persistence of bull markets in the LT,

PS and RS3L-models, but has no effect when the market is bearish. Other variables show

up less consistently. An increase in the unemployment rate during a bull market leads to

a higher probability of continuation in the PS and RS3L-model. In the PS-approach, a

higher term spread or a lower credit spread increases the probability of a switch from a

bear to a bull market, while in the RS2L-model they increase the probability that a bull

market continues. A higher T-bill rate decreases the probability of a bull market in the

LT-model.

To determine by how much the transition probabilities change when the predicting

variables change, we calculate the marginal effect that a one-standard deviation change

in a predicting variable has on a reference probability π. As a reference point we use the

average forecast probability

PT

Pr[St+1 = s|St = q, zt−1 ] Pr[St = q|Ωt ]

π̄sq = t=1 PT , (28)

t=1 Pr[St = q|Ωt ]

where Ωt denotes the information set (predicting and dependent variables) up to time t.

In this expression, each forecast probability Pr[St+1 = s|St = q, zt−1 ] of a switch from

state q to state s is weighted by the likelihood of an occurrence of state q at time t,

Pr[St = q|Ωt ]. In the rules based approaches, the weights are either zero or one. In

the regime-switching approaches the weights are the so-called inference probabilities. We

report these probabilities for the different regimes and models in the last row of Table C.2.

They confirm the strong persistence reported in Table C.1.

The marginal effects are calculated from the reference probability π and the coefficient

β. When logit transformations, the marginal effect of variable zi with coefficient βi is

given by π(1 − π)βi . For the multinomial logit transformation we derive the marginal

effects in Appendix A. Overall, marginal effects are small, with changes of around 0.01–

0.02. However, the probability of a switch from a bear to a bull market can still double.

For instance, in the PS-model, the marginal effect of a one-standard deviation rise in the

D/P-ratio increases the probability a bear-bull switch from 0.02 to 0.04.

64

Combining Tables C.1 and C.2, we conclude that all methods identify persistent bull

and bear markets. The evidence for time-variation is limited. However, if the sentiment

of the stock market is a good predictor of other economic processes, it is not surprising

that other economic variables fail to predict the stock market sentiment well. The D/P-

ratio which is closely related to expected returns in the stock market is most consistently

selected.

To judge the quality of the different models, we calculate and compare log likelihood values

in Table C.3. For all models, we can determine the added value of predictive variables in

the transition probabilities. By construction, these improvements are all significant. Also,

the Akaike Information Criterion favors the models with time-variation in the transition

probabilities over the models where they are constant. However, the improvements of the

likelihood are not enough to improve the Bayesian Information Criteration, which puts a

heavier penalty on additional parameters. We conclude that the evidence favoring time-

varying transition probabilities is at best marginal.

For the regime-switching models we can also evaluate the added value of an extra

regime. For both cases (constant and time-varying transition probabilities), an additional

regime leads to large improvements in the likelihood values. Both information criteria

prefer a model with three regimes over one with only two. When transition probabilities

are constant, the model with two regimes is nested in the model with three regimes, and

we could conduct a likelihood ratio test (the LR-statistic equals 105.50). However, due

to presence of nuisance parameters under the null-hypothesis of two regimes, the statistic

does not follow a standard χ2 distribution and simulations can be used. As our interest is

not in selecting the best statistical model we do not conduct this test here. Given the size

of the LR-statistic and the values of the information criteria, the evidence so far supports

a model with three regimes.

65

Table C.1: Constant Transition Probabilities

(a) Probability Estimates

from to LT PS RS2C RS3C

bull bull 0.992 0.990 0.981 0.986

bear 0.008 0.010 0.019 0.014

crash < 0.001

bear bull 0.015 0.016 0.052 0.019

bear 0.985 0.984 0.948 0.972

crash 0.009

crash bull < 0.001

bear 0.106

crash 0.894

LT PS RS2C RS3C

bull 0.652 0.615 0.730 0.570

(mild) bear 0.348 0.385 0.27 0.396

strong bear 0.034

This table shows the transition probabilities between the different regimes under the different approaches

and the resulting unconditional probabilities. We assume that the probabilities are constant over time. In

the approaches of LT and PS, we first apply their algorithms to identify the sequences of bull and bear

markets. As a second step we estimate the probabilities. For the regime switching models the probabilities

result directly from the estimation. The regime switching model can either have 2 regimes (RS2C) or 3

regimes (RS3C). The unconditional probabilities π̄ satisfy π̄ m P m = π̄ m .

66

Table C.2: Time-varying transition probabilities, (multinomial) logit models

model LT PS RS2L RS3L

from bull bear bull bear bull bear bull mild bear strong bear

to bull bull bull bull bull bull bull mild bear bull mild bear bull mild bear

constant 5.16 −5.32 5.23 −5.35 3.62 −2.33 88.58 83.35 −0.29 3.72 −63.27 0.18

inflation −0.34 − −0.85 − − − −1.04 − − − − −

[−0.003] [−0.008] [−0.013] [0.013]

prod. growth − − − − − − − − − − − −

[0.007] [0.012] [−0.012]

t-bill rate −0.77 − − − − − − − − − − −

[−0.006]

term spread − − − 0.70 0.32 − − − − − − −

[0.011] [0.009]

credit spread − − − −0.40 −0.68 − − − − − − −

67

[−0.006] [−0.018]

D/P ratio 0.76 1.01 1.05 1.25 − −0.43 1.14 − − − − −1.14

[0.006] [0.015] [0.010] [0.020] [−0.031] [0.014] [−0.014] [−0.207]

π̄sq 0.99 0.02 0.99 0.02 0.97 0.08 0.99 0.01 0.02 0.96 < 0.01 0.24

This table shows the estimated coefficients and marginal effects of the predicting variables, when they are linked to the transition probabilities

by (multinomial) logit models. The predicting variables have been standardized by subtracting their full-sample mean and dividing by their

full-sample standard deviation. In the approaches of LT and PS, we first apply the algorithms to identify bullish and bearish periods. In the

second step we estimate a Markovian logit model as in (1), where the coefficients depend on the departure state. In the two-state regime

switching model, RS2L, the logistic transformation in (6) is used to link the predicting variables to the transition probabilities. For the three-

state regime switching model, RS3L, the multinomial logistic transformation in (5) is used. In that case the coefficients for a switch to the strong

bear regime have been fixed at zero. The variable-transition combinations that subsequently produce the biggest increase in the likelihood

function are included in the models. The procedure stops when the remaining variable-transition combinations fail to produce an increase in

the likelihood function that is significant on the 10%-level. For the RS3L-model we allow a maximum of four combinations to be included. The

marginal effects in brackets are calculated for the average forecast probability π̄sq reported in the last row of the table. The average forecast

probability is calculated as in (28). For the two-state approaches, the marginal effect of variable i is calculated as π̄sq (1 − π̄sq )βqi . For the

three-state approaches, the marginal effect is given by (5).

Table C.3: Log likelihood values and information criteria of different model specifi-

cations

LT PS RS2 RS3

constant # parameters 2 2 7 14

log L -170.12 -192.61 -5979.75 -5927.01

AIC 0.119 0.134 4.136 4.104

BIC 0.123 0.139 4.150 4.133

time-varying # parameters 6 8 11 18

log L -153.82 -168.63 -5970.87 -5916.96

AIC 0.110 0.122 4.133 4.100

BIC 0.123 0.139 4.155 4.137

LR 32.60 47.96 17.78 20.09

df 4 6 4 4

Pr(0.01) 13.28 16.81 13.28 13.28

This table shows the log likelihood values of the different models. For the rules-based approaches LT and

PS, we report the log likelihood values of the Markovian logit models as in (1). For the regime switching

models with two or three states, we report the likelihood of the complete model. The transition probabilities

can be constant (corresponding with Table C.1) or time-varying (corresponding with Table C.2). Based

on the log likelihood values we calculate the Akaike and Bayesian Information Criterion (AIC and BIC).

In the row labeled “LR” we report the likelihood ratio statistic for time-varying vs. constant transition

probabilities, which has a χ2 distribution with degrees of freedom listed in the row below. The last row

reports 1% critical values of the corresponding χ2 distribution.

68

D Additional Results on Predictions

In the experiment to compare the predictions of the various methods, we reestimate the

parameters of the different models every 52 weeks. Here we show how the different param-

eters evolve. Besides aiding our understanding of the predictions, it also shows how robust

the parameters and characteristics are when more information becomes available.

Figure D.1 shows the evolution of the means and volatilities of the different regimes.

In the rules-based approaches, we first do the identification, and estimate means and

volatilities based on that. In the regime-switching approaches, we estimate means and

volatilities directly. Generally, we see that the means and volatilities are stable. As we

concluded in the full-sample analysis, the difference between the mean for the bull and

for the bear regime is more extreme for the rules-based approaches, while the difference

between the volatilities for these two regimes is more extreme for the RS2-models.

The evolution of the means and volatilities of the regimes in the RS3-models in Fig-

ures D.1e and D.1f indicates the influence of the credit crisis. When data until May 2008

is used, two bullish and one bearish regime are identified. One regime has strongly bullish

characteristics with a high mean and a low volatility, while the other is more mild, with a

mean slightly above zero, and a higher volatility. The characteristics of the bearish regime

match quite well with those of the bearish regime in the RS2-models. After 2008, one

bullish and two bearish regimes show up. One bearish regime has mild characteristics,

while the other has much stronger bearish features. It stresses the exceptional behavior of

the US stock market during the credit crisis.

The evolution of the transition probabilities when assumed constant within an estima-

tion window are in Figure D.2. The methods with two states produce transition prob-

abilities that are also quite stable over time. Persistence is high for both regimes. The

probability of remaining in a bull state never falls below 0.95. For the rules-based ap-

proaches, the same applies to the bear regime. In the RS2C model, a bear market seems

slightly less persistent, but the probability of continuation almost always exceeds 0.90.

69

The transition probabilities in the RS3C-model vary a bit more than in the two-state

models, in particular the probabilities for a switch to another regime. For example, the

probability of a switch from a (strongly) bearish to a mildly bullish/bearish regime ranges

from 0.04 to 0.11. The probabilities that a specific regime continues are high (around 0.90

or more) and quite stable.

The parameter dynamics of the models for time-varying transition probabilities in Fig-

ure D.3 indicate whether the parameters are stable, but also whether the variable selection

is stable. In the rules-based method, the selection and the parameters are quite stable.

The D/P-ratio is consistently present for all switches in both the LT and PS-methods.

The T-bill rate is selected for predictions from the bullish regime in both models. In the

PS-method, the inflation rate, the unemployment rate and the term spread also show up

consistently. In the LT-approach, these are sometimes selected. In the RS-models the

selection shows a more haphazard pattern. However, given that a variable is selected, the

corresponding coefficient is stable.

70

Figure D.1: Evolution of means and volatilities per regime

LT PS RS2C RS2L LT PS RS2C RS2L

0.5 0

-0.1

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(a) mean of bull regimes in two-state models (b) mean of bear regimes in two-state models

LT PS RS2C RS2L LT PS RS2C RS2L

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This figure shows the evolution of the means and volatilities when estimated with an expanding window

(end date on the x-axis). The first window comprises the period January 7, 1955 – June 24, 1983 (1485

observations), and is continuously expanded with 52 weeks until we reach the end of the sample (July 2,

2010). In the approaches of LT and PS, we first apply their algorithms to identify the sequences of bull and

bear markets for each estimation window. As a second step we calculate means and volatilities per regime.

The regime switching models can either have two regimes or three regimes, and constant or time-varying

transition probabilities. The means and volatilities of the regimes follow directly from the estimation.

71

Figure D.2: Evolution of constant transition probabilities

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This figure shows the evolution of the transition probabilities when estimated with an expanding window

(end date on the x-axis). We assume that the probabilities are constant within each estimation window.

The first window comprises the period January 7, 1955 – June 24, 1983 (1485 observations), and is

continuously expanded with 52 weeks until we reach the end of the sample (July 2, 2010). In the approaches

of LT and PS, we first apply their algorithms to identify the sequences of bull and bear markets for each

estimation window. As a second step we estimate the probabilities. For the regime switching models the

probabilities result directly from the estimation. The regime switching models can either have two regimes

(RS2C) or three regimes (RS3C). For the methods with two states, we plot the probabilities of a bull-bull

and a bear-bear switch in Panel (a). For the RS3C-model in Panel (b) we indicate the transition in the

legend above the subfigure. Dashed lines correspond with the secondary y-axis. We do not show transition

probabilities that never exceed 0.001.

72

Figure note on next page.

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This figure plots the evolution of the coefficients in the (multinomial) logit transitions for the predicting

variables in Table B.1, when estimated with an expanding window (end date on the x-axis). The first

window comprises the period January 7, 1955 – June 24, 1983 (1485 observations), and is continuously

expanded with 52 weeks until we reach the end of the sample (July 2, 2010). The predicting variables

have been standardized by subtracting their full-sample mean and dividing by their full-sample standard

deviation. In the approaches of LT and PS, we first apply the algorithms to identify bullish and bearish

periods in the subperiod under consideration. In the second step we estimate a Markovian logit model as

in (1), where the coefficients depend on the departure state. In the RS2L-model the logistic transformation

in (6) is used to link the predicting variables to the transition probabilities. In the RS3L, the multinomial

logistic transformation in (5) is used. For identification, all coefficients for a switch to the (strong) bear

regime have been fixed at zero. The variable-transition combinations that subsequently produce the biggest

increase in the likelihood function are included in the models. The procedure stops when the remaining

74

variable-transition combinations fail to produce an increase in the likelihood function that is significant on

the 10%-level. In each subfigure, we only plot the variables that have been selected at least once.

E Result of Robustness Checks

Lunde and Timmermann (2004) consider four combinations for the values of the thresholds

λ1 and λ2 to identify switches between bull and bear markets. They argue that a value of

20% for λ1 is conventionally used. A lower value of 15% for λ2 subsequently accounts for

the positive drift of the stock market. Other combinations they consider for (λ1 , λ2 ) are

(0.20, 0.10), (0.15, 0.15) and (0.15, 0.10). Since we conclude that a quick identification of

the current state is important when making predictions, we follow LT and also consider

these combinations of lower thresholds.

Lower thresholds lead to a more rapid alternation of bull and bear markets, that as a

consequence will last briefer. When we consider identification based on the full sample, the

number of cycles increases from 16 in the original (0.20, 0.15) setting to 24 for the lowest

thresholds (0.15, 0.10). Lowering both thresholds has a much stronger effect than lowering

only one of the thresholds. Average and median durations decrease when we work with

lower threholds, though the result is less pronounced than in LT. This is due the fact that

the longest bull market is unaffected by the choice of thresholds.

and predictions are that results from the LT-method with different thresholds. Table E.2a

shows that the integrated absolute difference between these series is quite small. Their

average difference varies between 0.011 and 0.059, while the upper bound of the 90%

confidence intervals is around 0.10. Comparing these difference with those in Table 3

shows that they are slightly smaller than the difference between the standard LT and the

PS identifications, and much smaller than the differences between the standard LT-method

and the RS-methods. So from a statistical point of view, the type of method matters more

than the specific thresholds.

75

The economic comparison in Tables E.2b and E.2c shows larger differences. A faster

identification of bull and bear markets leads to a considerably higher mean, rising from

48.1% to 66.3% per year, at the cost of a slight increase in the volatility from 30.3% to

35.2%. As a consequence, both the Sharpe ratio and the realized utility increase. An

investor would be willing to pay large fees up to 9.67% to switch to lower thresholds. Since

fees to switch from the standard (0.20, 0.15) are all positive, the fees in Table 4b may un-

derestimate the preference of the standard LT-method over the regime switching methods.

The fees to switch from (0.20, 0.15) to (0.15, 0.10) are significant, as confidence intervals

are substantially bounded from zero. Only the joint lowering of thresholds commands a

significant fee. However, these fees correspond with identification ex post, and it is not

obvious that working with lower thresholds leads to better predictions or allocations ex

ante.

We turn to the predictions made with different thresholds in Table E.3. Lowering

thresholds leads to a higher predictive accuracy. In particular bear markets are better

predicted with lower thresholds. We conclude from these results that an exceedance of

a lower threshold suffices to mark a definite switch between bull and bear markets. The

lowest thresholds produce the largest hit rate and Kuipers score and the lowest IAD with

the final identification. These numbers put the LT-method with lowest thresholds at par

with the two state regime switching models in Table 5.

The IAD-measures in Table E.4 indicate that the differences between predictions based

on the different threshold combinations are larger than those between identification. Logi-

cally, IADs are larger when both threshold values are different, with maxima around 0.16,

meaning that 16% of the predictions are different. Confidence intervals indicate that the

differences are significant. A comparison with Table 6 shows that the predictions by LT-

method with different thresholds still have more in common than the standard LT-method

with the other methods, including the PS method. In line with earlier results, the use of

predictive variables only leads to marginal differences in the predictions.

76

Finally, we compare the performance of investment strategies that are based on the LT-

methods with different thresholds in Table E.5. Lower thresholds lead to higher means,

which rise from around 8% to 12%, but also to higher volatilities. Part of the increases come

from a larger position in futures contracts. Judged by Sharpe ratio and realized utility, the

threshold combination (0.20, 0.15) works best, while a lowering of the λ1 threshold actually

leads lower utility because of the increase in volatility. The highest utility in Table E.5a is

still lower that the utilities for the regime switching models in Table 7a.

The fees in Table E.5b indicate that the economic improvement of a strategy by one

threshold combination compared to another combination is still relatively small and mostly

insignificant. Changing from the standard (0.20, 0.15) combination to the (0.20, 0.10) com-

mands a fee of 4–6% per year, but the confidence intervals are quite wide and stretch beyond

zero. The only significant fees correspond with a switch from the (0.15, 0.10) combination

with constant transition probabilities. The magnitude of the fees is small compared to the

fees reported in Table 7. Lowering the thresholds leads to better identification but also to

more risk-taking, which in the end makes a slower, more cautious strategy more attractive.

Overall, we conclude that lowering the thresholds improves identification and predic-

tions. Lower thresholds lead to better identification, both in a statistical and an economic

performance. We already concluded that the rules-based methods are better suited for

identification. The results for lower thresholds indicate an even larger difference. For pre-

dictions, the results are more mixed. If hits and false alarms are equally important, lower

thresholds improve the performance of the LT-methods to a level comparable to the two-

state regime switching models. However, the economic comparison shows that the false

alarms actually become costlier, and the overall balance in terms of economic performance

is negative. Nonetheless, lowering the threshold λ2 makes sense as a switch to this setting

commands a positive fee and leads to higher utility. Since utility is still considerably lower

than the level produced by the regime-switching models, these models lead to predictions

that are economically more valuable.

77

E.2 Robustness of the PS-method

Pagan and Sossounov (2003) base their algorithm on the algorithm for business cycle

identification of Bry and Boschan (1971), and adjust some of the original settings based

on early literature on bull and bear markets, the so-called Dow theory after Charles Dow.

They do not investigate how robust their findings are to changes in these settings. We

conduct a small robustness investigation, where we change one parameter at a time. In

comparison with the LT-method, the PS-method identifies a few more cycles, so we consider

only a relaxation of the constraint on cycle length, which we lower to 52 weeks instead of

70. For the constraint on the length of a phase, we consider a lower value of 12 weeks and a

higher value of 20 weeks. A higher value may lead to less false alarms. The bound on price

change that must be crossed to overrule the phase constraint is currently at 20%. As in the

robustness checks for the LT-method, we consider a value of 15%. Censoring (currently

13 weeks) will not influence the identification much, but may have considerable impact on

predictions. We consider a lower value of 7 weeks and a higher value of 26 weeks, which

corresponds with the setting of PS.

We find that the identification is quite robust to these changes. In the basic setting,

we identify 18 bull and 18 bear markets (see Table 1). The results do not change at all,

when we change the phase constraint or the price change bound. Censoring 7 weeks at

the beginning and end leads to one extra switch to a bear market at the end of of the

sample. Censoring 26 weeks does not lead to different results. Lowering the cycle to 52

weeks leads to 19 bull and 19 bear markets. Because results change at most slightly, the

further analyses based on identification will also change only slightly. Our conclusion that

the PS-method works well for identification remains unaffected.

The predictions and allocations based on the PS-method change more when the pa-

rameters are changed. A prediction for week t + 1 based on the PS-method uses only

information up to time t. The identification over the subsample until week t may differ

from the full-sample identification and may be more sensitive to parameter choices. This

larger sensitivity then carries over to the predictions.

Table E.6 show the sensitivity of predictive accuracy for the restrictions. The hit rate

for bull markets changes a bit (at most 10%), while the hit rate for bear markets shows

78

more variation. However, an improvement in correctly predicting bull markets is offset by

a deterioration for bear markets. The overall hit rates remain steadily between 70–75%.

This result contrasts with the results for the LT-method in Table E.3, which shows more

variation.

Table E.7 shows a further analysis of the impact of parameter changes. Censoring

leads to predictions that are quite different from the predictions in the basic setting, with

IADs of around 0.l7 when 7 weeks are censored and 0.22 when 26 weeks are censored.

Less censoring leads to a more aggressive allocation with weights larger than two, while

more censoring leads to a less aggressive allocation with weights close to one. This pattern

is caused by predictions being closer to the steady state distribution of bull and bear

markets, when more observations are censored. Effectively, more censoring necessitates

a prediction for more steps ahead. More censoring and less aggressive investments lead

to a better performance: the mean increases while the volatility decreases. Less censoring

shows the opposite effect. It means that the predictions are too extreme, and that shrinking

them towards their long-term average makes sense. The effect of more censoring is quite

impressive with a Sharpe ratio that increases to 0.37 when predictive variables are used.

This ratio is similar in magnitude to the best LT-method in the previous subsection.

Moreover, utility increases compared to the basis strategies. The resulting utility is only

slightly lower than the utility the results from using two-state regime switching models.

Because more censoring leads to higher utility, an investor is willing to pay significant fees

of around 14% per year to switch from the basic PS-method.

All other parameter choices do not matter much. Changing the phase constraint does

not give different results. When we put the constraint at 12 or 20 weeks, the predictions

are exactly the same as in the basic setting. Therefore we have not include the phase con-

straint in a further analysis. A relaxation of the constraints on the duration of a cycle or

the price change to trigger a switch do not lead to large statistical or economic differences

79

in Table E.7. The characteristics of the investment strategies are largely similar. Conse-

quently, fees for switching differ only a little bit from zero. The confidence intervals for

the IADs and the fees encompass zero, indicating that the differences are not significant.

80

Table E.1: Number and Duration of Market Regimes for Different Thresholds in the

LT-method

λ1 0.20 0.20 0.15 0.15

λ2 0.15 0.10 0.15 0.10

bull number 16 18 18 24

avg. duration 119 98 108 77

med. duration 90 59 84 50

std. dev. duration 97 97 97 90

max. duration 405 405 405 405

min. duration 15 15 6 5

bear number 16 18 18 24

avg. duration 62 63 53 44

med. duration 60 55 60 39

std. dev. duration 44 49 29 30

max. duration 187 187 91 91

min. duration 7 7 7 4

This table shows the number of spells of the different market regimes, their average and median duration,

the standard deviation of the duration, and its maximum and minimum for different thresholds λ1 and λ2.

81

Table E.2: Statistical and Economic Comparison of the Identification by the LT-

method for Different Thresholds

(a) Integrated Absolute Distances

(λ1 , λ2 ) (0.20, 0.10) (0.15, 0.15) (0.15, 0.10)

(0.20, 0.15) 0.047 0.011 0.045

[0.017, 0.102] [0.000, 0.059] [0.034, 0.112]

(0.20, 0.10) 0.059 0.038

[0.031, 0.126] [0.014, 0.087]

(0.15, 0.15) 0.033

[0.017, 0.089]

(λ1 , λ2 ) (0.20, 0.15) (0.20, 0.10) (0.15, 0.15) (0.15, 0.10)

Mean 48.1 51.8 52.8 66.3

Volatility 30.3 31.4 31.7 35.2

Sharpe ratio 1.59 1.65 1.67 1.88

Utility 0.241 0.259 0.264 0.331

(c) Fees

(λ1 , λ2 ) (0.20, 0.15) (0.20, 0.10) (0.15, 0.15) (0.15, 0.10)

(0.20, 0.15) 0 -1.94 -2.48 -9.59

[-7.57, -0.41] [-6.73, 0.00] [-16.83, -5.89]

(0.20, 0.10) 1.94 0 -0.54 -7.66

[0.41, 7.62] [-4.45, 4.98] [-12.61, -3.78]

(0.15, 0.15) 2.49 0.54 0 -7.12

[0.00, 6.77] [-4.96, 4.47] [-13.66, -3.36]

(0.15, 0.10) 9.67 7.72 7.17 0

[5.92, 17.09] [3.80, 12.76] [3.37, 13.83]

This table shows the statistical and economic comparison of the identification that results from the LT-

method when different thresholds λ1 and λ2 are used. The statistics are calculated as in Tables 3 and 4.

82

Table E.3: Predictive Accuracy based on the LT-method with Different Thresholds

(λ1 , λ2 ) (0.20, 0.15) (0.20, 0.10) (0.15, 0.15) (0.15, 0.10)

Transition C L C L C L C L

Bull correct 852 851 816 819 983 977 934 941

Bull wrong 214 215 214 211 89 95 111 104

% Bull correct 79.9% 79.8% 79.2% 79.5% 91.7% 91.1% 89.4% 90.0%

Bear correct 150 132 263 249 137 137 232 232

Bear wrong 194 212 117 131 201 201 133 133

% Bear correct 43.6% 38.4% 69.2% 65.5% 40.5% 40.5% 63.6% 63.6%

Total correct 1002 983 1079 1068 1120 1114 1166 1173

Total false 408 427 331 342 290 296 244 237

% Correct 71.1% 69.7% 76.5% 75.7% 79.4% 79.0% 82.7% 83.2%

Default bull 75.6% 75.6% 73.0% 73.0% 76.0% 76.0% 74.1% 74.1%

Improvement -4.5% -5.9% 3.5% 2.7% 3.4% 3.0% 8.6% 9.1%

Kuipers Score 23.5% 18.2% 48.4% 45.0% 32.2% 31.7% 52.9% 53.6%

IAD 0.194 0.222 0.153 0.171 0.160 0.159 0.132 0.127

See Table 5 for explanation. A C in the row transition means that transition probabilities are constant,

and an L means they are modelled with the Markovian logit-model.

83

Table E.4: Integrated Absolute Difference of Predictions based on the LT-method with Different Settings

(0.20, 0.15, C) (0.20, 0.15, L) (0.20, 0.10, C) (0.20, 0.10, L (0.15, 0.15, C) (0.15, 0.15, L) (0.15, 0.10, C)

(0.20, 0.15, L) 0.060 0.067 0.113 0.067 0.106 0.127 0.150

[0.057, 0.110] [0.035, 0.136] [0.096, 0.206] [0.032, 0.099] [0.097, 0.166] [0.092, 0.180] [0.139, 0.239]

(0.20, 0.10, C) 0.116 0.098 0.113 0.077 0.165 0.162

[0.096, 0.185] [0.073, 0.181] [0.083, 0.162] [0.038, 0.119] [0.122, 0.207] [0.119, 0.217]

(0.20, 0.10, L) 0.063 0.128 0.161 0.080 0.116

[0.041, 0.105] [0.094, 0.204] [0.142, 0.242] [0.052, 0.116] [0.101, 0.172]

(0.15, 0.15, C) 0.163 0.155 0.121 0.101

[0.121, 0.247] [0.108, 0.213] [0.089, 0.161] [0.065, 0.135]

84

[0.056, 0.104] [0.055, 0.134] [0.104, 0.192]

(0.15, 0.10, C) 0.118 0.109

[0.107, 0.181] [0.086, 0.165]

(0.15, 0.10, L) 0.054

[0.055, 0.093]

This table reports the integrated absolute distance between the predictions of the LT-method constructed with different thresholds and with

constant or time-varying transition probabilities. The settings are reported in the headings in parentheses, where the first two elements indicate

the values for λ1 and λ2 and the third element indicates constant (C) or time-varying (L) transition probabilities. See Table 6 for further

explanation.

Table E.5: Performance Measures and Fees when Predictions are based on the LT-method with Different Settings

(a) Performance Measures

(λ1 , λ2 ) (0.20, 0.15) (0.20, 0.10) (0.15, 0.15) (0.15, 0.10)

Transition C L C L C L C L

Av. Abs. Weight 1.82 1.90 1.91 2.04 1.91 1.96 2.15 2.26

Mean 8.73 7.13 13.33 14.10 9.18 10.36 12.04 14.36

Mean Bull 8.96 10.30 12.28 15.19 10.31 13.90 9.87 14.07

Mean Bear 8.01 -2.69 16.17 11.15 5.60 -0.89 18.27 15.17

Volatility 32.4 31.9 32.8 32.7 33.8 33.3 37.7 36.8

Sharpe Ratio 0.27 0.22 0.41 0.43 0.27 0.31 0.32 0.39

Utility -0.176 -0.184 -0.136 -0.127 -0.194 -0.175 -0.235 -0.195

(b) Fees

(λ1 , λ2 ) (0.20, 0.15) (0.20, 0.10) (0.15, 0.15) (0.15, 0.10)

Transition C L C L C L C L

(0.20, 0.15, C) 0 0.82 -3.99 -4.94 1.77 -0.10 5.93 1.93

85

[-5.18, 1.86] [-5.89, 3.21] [-8.76, 2.44] [-1.72, 7.94] [-5.71, 3.81] [1.66, 16.00] [-3.76, 10.90]

(0.20, 0.15, L) -0.81 0 -4.80 -5.76 0.95 -0.92 5.11 1.11

[-1.86, 5.17] [-5.82, 6.85] [-6.88, 3.91] [-2.08, 11.81] [-2.73, 5.36] [1.81, 20.64] [-2.03, 13.67]

(0.20, 0.10, C) 3.99 4.81 0 -0.96 5.76 3.89 9.92 5.92

[-3.22, 5.89] [-6.90, 5.82] [-5.58, 0.87] [-2.87, 11.00] [-6.22, 7.11] [2.83, 16.35] [-1.66, 11.50]

(0.20, 0.10, L) 4.95 5.76 0.96 0 6.71 4.84 10.87 6.87

[-2.45, 8.72] [-3.92, 6.90] [-0.87, 5.55] [-2.38, 14.75] [-4.25, 8.74] [4.50, 19.26] [1.46, 13.52]

(0.15, 0.15, C) -1.77 -0.95 -5.77 -6.73 0 -1.87 4.17 0.16

[-7.97, 1.73] [-11.89, 2.08] [-11.01, 2.87] [-14.89, 2.38] [-8.86, 1.06] [-0.71, 13.15] [-8.96, 9.36]

(0.15, 0.15, L) 0.10 0.92 -3.89 -4.85 1.87 0 6.04 2.03

[-3.82, 5.70] [-5.39, 2.73] [-7.10, 6.20] [-8.77, 4.25] [-1.06, 8.79] [1.97, 18.68] [-3.13, 12.16]

(0.15, 0.10, C) -5.98 -5.16 -10.00 -10.97 -4.20 -6.08 0 -4.03

[-16.21, -1.67] [-20.99, -1.83] [-16.56, -2.85] [-19.60, -4.53] [-13.25, 0.72] [-18.93, -1.98] [-11.13, -0.39]

(0.15, 0.10, L) -1.94 -1.12 -5.96 -6.92 -0.16 -2.04 4.03 0

[-10.99, 3.77] [-13.78, 2.05] [-11.60, 1.66] [-13.61, -1.47] [-9.42, 8.95] [-12.26, 3.14] [0.39, 11.06]

See Table 7 for explanation. The different settings in the LT-method are indicated by the values for λ1 and λ2 and the choice for transition

probabilities, which can be constant (C) or time-varying (L).

Table E.6: Predictive Accuracy of the PS-method with Different Settings

Setting basic censoring: 7 censoring: 26 cycle: 52 change: 15%

Transition C L C L C L C L C L

Bull correct 768 779 706 714 760 792 768 874 770 781

Bull wrong 193 182 245 237 201 169 193 87 191 180

% Bull correct 79.9% 81.1% 74.2% 75.1% 79.1% 82.4% 79.9% 90.9% 80.1% 81.3%

Bear correct 281 261 295 281 235 207 261 145 281 261

Bear wrong 168 188 164 178 214 242 188 304 168 188

% Bear correct 62.6% 58.1% 64.3% 61.2% 52.3% 46.1% 58.1% 32.3% 62.6% 58.1%

Total correct 1049 1040 1001 995 995 999 1029 1019 1051 1042

Total false 361 370 409 415 415 411 381 391 359 368

% Correct 74.4% 73.8% 71.0% 70.6% 70.6% 70.9% 73.0% 72.3% 74.5% 73.9%

Default bull 68.2% 68.2% 67.4% 67.4% 68.2% 68.2% 68.2% 68.2% 68.2% 68.2%

Improvement 6.2% 5.6% 3.5% 3.1% 2.4% 2.7% 4.8% 4.1% 6.4% 5.7%

Kuipers Score 42.5% 39.2% 38.5% 36.3% 31.4% 28.5% 38.0% 23.2% 42.7% 39.4%

IAD 0.177 0.197 0.239 0.262 0.144 0.161 0.194 0.210 0.176 0.196

This table show the predictive accuracy of the PS-method when one parameter is changed. The basis

setting is used throughout the paper. It censors 13 weeks at the beginning and end. It requires cycles to

be longer than 70 weeks. Phases should be longer than 16 weeks unless the price changes with more then

20% since the last peak or trough. The column headings indicate which value is used for a parameter. All

other parameters are set to their basic value. Transition probabilities can be constant (indicated by a C)

or time-varying (indicated by an L). See Table 5 for further explanation.

86

Table E.7: Statistical and Economic Comparison of Predictions based on the PS-method with Different Settings

Setting IAD Av. Abs. Mean Mean Mean Vol. Sharpe Utility Fee

Weight Mean Bull Bear Ratio

Basic, C 0 1.70 1.48 0.97 2.56 28.0 0.05 -0.181 0

Basic, L 0 1.87 2.26 5.61 -4.91 30.1 0.08 -0.203 0

Censoring: 7, C 0.175 [0.158, 0.188] 2.01 -5.32 -9.70 3.74 32.9 -0.16 -0.324 -14.31 [-22.54, -3.91]

Censoring: 7, L 0.169 [0.153, 0.185] 2.13 -3.84 -5.65 -0.07 34.4 -0.11 -0.335 -13.19 [-22.23, -1.95]

Censoring: 26, C 0.212 [0.186, 0.228] 1.20 5.33 7.67 0.33 19.7 0.27 -0.043 13.73 [6.22, 19.57]

Censoring: 26, L 0.222 [0.181, 0.243] 1.42 9.05 16.04 -5.91 24.6 0.37 -0.061 14.22 [1.91, 16.03]

Cycle: 52, C 0.009 1.71 1.57 1.38 1.98 28.0 0.06 -0.181 0.02

Cycle: 52, L 0.028 1.81 0.48 4.07 -7.21 29.7 0.02 -0.216 -1.25

87

Change: 15%, C 0.001 [0.000, 0.023] 1.70 2.10 1.89 2.56 28.0 0.08 -0.175 0.62 [-0.16, 2.03]

Change: 15%, L 0.001 [0.000, 0.029] 1.87 3.08 6.82 -4.91 30.1 0.10 -0.195 0.82 [-0.21, 2.65]

The column IAD gives the Integrated Absolute Distance between the predictions based on a specific setting and the basic setting for the

PS-method. The next columns subsequently report performance measures of investment strategies that use the different predictions as input

for an asset allocation as discussed in Section 3.2. We report the average absolute weight of each strategy. Based on the realized returns of

the asset allocations, we calculate the mean and volatility (in % per year), the yearly Sharpe ratio, and the annualized realized utility as in

Eq. (13). Mean Bull (Mean Bear) is the annualized mean during the subperiods identified ex post as bull (bear) markets. The column fee

reports the maximum fee that an investor is willing to pay to switch from a basic setting to another setting in the PS-method. We express

the fees in % per year. When calculating the IAD or the fee, the setting for the transition probabilities (constant or time-varying) in the basic

strategy corresponds with the setting in the alternative method. We report the 5% and 95% percentiles between brackets for the IAD and the

fee based on the 200 bootstraps of both the return and the explanatory variable series following Politis and Romano (1994). We do not report

confidence intervals for the different cycle restrictions, as changing cycle minima cannot be combined with a stationary bootstrap.

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