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Not all bull and bear markets are alike: insights from a five-state hidden semi-Markov model

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  • Valeriy Zakamulin

    (University of Agder)

Abstract

This paper employs the hidden semi-Markov model and a novel model selection procedure to determine different regimes in the US stock market. The empirical results suggest that the US stock market is switching between five states that can be classified into three bull states and two bear states. The three bull states are categorized as a low-volatility bull market, a high-volatility bull market, and a stock market bubble. One of the bear states represents a regular bear market, while the other corresponds to either a stock market crash or a market correction. The paper demonstrates that the five-state model is consistent with a number of stylized facts and provides many valuable insights into the regime-switching dynamics of the US stock market and the risk-reward pattern of each regime. Besides, the paper demonstrates that the five-state model enables investors to make better asset allocation decisions. Specifically, in out-of-sample tests, the asset allocation strategy based on the five-state model achieves higher performance with lower risk than the strategy based on the two-state model and the buy-and-hold benchmark.

Suggested Citation

  • Valeriy Zakamulin, 2023. "Not all bull and bear markets are alike: insights from a five-state hidden semi-Markov model," Risk Management, Palgrave Macmillan, vol. 25(1), pages 1-25, March.
    • Handle: RePEc:pal:risman:v:25:y:2023:i:1:d:10.1057_s41283-022-00112-y
    DOI: 10.1057/s41283-022-00112-y
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    More about this item

    Keywords

    Semi-Markov models; Stock market regimes; Bull and bear markets; US stock market; Optimal asset allocation;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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