The Aligned Economic Index & The State Switching Model
Fuente:
arXiv
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| Natura: | Preprint |
| Pubblicazione: |
2025
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| _version_ | 1866912792945098752 |
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| author | Aarab, Ilias |
| author_facet | Aarab, Ilias |
| contents | A growing empirical literature suggests that equity-premium predictability is state dependent, with much of the forecasting power concentrated around recessionary periods (Henkel et al., 2011; Dangl and Halling, 2012; Devpura et al., 2018). I study U.S. stock return predictability across economic regimes and document strong evidence of time-varying expected returns across both expansionary and contractionary states. I contribute in two ways. First, I introduce a state-switching predictive regression in which the market state is defined in real time using the slope of the yield curve. Relative to the standard one-state predictive regression, the state-switching specification increases both in-sample and out-of-sample performance for the set of popular predictors considered by Welch and Goyal (2008), improving the out-of-sample performance of most predictors in economically meaningful ways. Second, I propose a new aggregate predictor, the Aligned Economic Index, constructed via partial least squares (PLS). Under the state-switching model, the Aligned Economic Index exhibits statistically and economically significant predictive power in sample and out of sample, and it outperforms widely used benchmark predictors and alternative predictor-combination methods. |
| format | Preprint |
| id |
arxiv_https___arxiv_org_abs_2512_20460 |
| institution | arXiv |
| publishDate | 2025 |
| record_format | arxiv |
| spellingShingle | The Aligned Economic Index & The State Switching Model Aarab, Ilias Statistical Finance Machine Learning Econometrics Portfolio Management Applications 62P20, 62M10, 91B84 A growing empirical literature suggests that equity-premium predictability is state dependent, with much of the forecasting power concentrated around recessionary periods (Henkel et al., 2011; Dangl and Halling, 2012; Devpura et al., 2018). I study U.S. stock return predictability across economic regimes and document strong evidence of time-varying expected returns across both expansionary and contractionary states. I contribute in two ways. First, I introduce a state-switching predictive regression in which the market state is defined in real time using the slope of the yield curve. Relative to the standard one-state predictive regression, the state-switching specification increases both in-sample and out-of-sample performance for the set of popular predictors considered by Welch and Goyal (2008), improving the out-of-sample performance of most predictors in economically meaningful ways. Second, I propose a new aggregate predictor, the Aligned Economic Index, constructed via partial least squares (PLS). Under the state-switching model, the Aligned Economic Index exhibits statistically and economically significant predictive power in sample and out of sample, and it outperforms widely used benchmark predictors and alternative predictor-combination methods. |
| title | The Aligned Economic Index & The State Switching Model |
| topic | Statistical Finance Machine Learning Econometrics Portfolio Management Applications 62P20, 62M10, 91B84 |
| url | https://arxiv.org/abs/2512.20460 |