Switching between states and the COVID-19 turbulence

Abstract

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