How to Identify and Predict Bull and Bear Markets?∗ Erik

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