Regime Switching in Stock Market Returns

In this paper, we use an extension of Hamilton's (1989) Markov switching techniques to describe and analyze stock market returns. Using new tests, we find very strong evidence of switching behaviour. A major innovation of our work is to use a multivariate specification which allows us to examine whether the price-dividend ratio has marginal predictive power for stock market returns after accounting for state-dependent switching. We find strong evidence of predictability. The response of returns to the past price-dividend ratio is strongly asymmetric - about four times larger in the low-return state than in the high-return state. A second innovation in our work is to allow the probability of transitions from one regime to another to depend on economic variables.