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The Aligned Economic Index & The State Switching Model

Ilias Aarab

TL;DR

The paper develops a real-time state-switching predictive regression using the yield-curve slope to define market regimes and introduces the Aligned Economic Index (E^{PLS}) built via partial least squares to integrate 16 predictors. Allowing regression coefficients to vary by state improves both in-sample and out-of-sample predictability of the equity premium, with strong gains under recessions and regime transitions. The Aligned Economic Index delivers superior predictive power relative to PCA-based factors and forecast combinations, and its effectiveness is amplified when used within the state-switching framework. Collectively, the approach offers a practically useful, regime-aware forecasting framework with substantial out-of-sample benefits across economic states.

Abstract

A growing empirical literature suggests that equity-premium predictability is state dependent, with much of the forecasting power concentrated around recessionary periods \parencite{Henkel2011,DanglHalling2012,Devpura2018}. 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 \textcite{WelchGoyal2008}, 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.

The Aligned Economic Index & The State Switching Model

TL;DR

The paper develops a real-time state-switching predictive regression using the yield-curve slope to define market regimes and introduces the Aligned Economic Index (E^{PLS}) built via partial least squares to integrate 16 predictors. Allowing regression coefficients to vary by state improves both in-sample and out-of-sample predictability of the equity premium, with strong gains under recessions and regime transitions. The Aligned Economic Index delivers superior predictive power relative to PCA-based factors and forecast combinations, and its effectiveness is amplified when used within the state-switching framework. Collectively, the approach offers a practically useful, regime-aware forecasting framework with substantial out-of-sample benefits across economic states.

Abstract

A growing empirical literature suggests that equity-premium predictability is state dependent, with much of the forecasting power concentrated around recessionary periods \parencite{Henkel2011,DanglHalling2012,Devpura2018}. 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 \textcite{WelchGoyal2008}, 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.
Paper Structure (10 sections, 12 equations, 3 figures, 2 tables)

This paper contains 10 sections, 12 equations, 3 figures, 2 tables.

Table of Contents

  1. Introduction
  2. Data
  3. Methodology
  4. Return predictability and switching between states
  5. The state-switching model
  6. The Aligned Economic Index
  7. Empirical Results
  8. $E^{PLS}$ versus $E^{FC}$
  9. Concluding remarks
  10. Construction of the Aligned Economic Index

Figures (3)

  • Figure 1: The Aligned Economic Index and the equity premium. The upper panel depicts the Aligned Economic Index $E^{PLS}$; the lower panel shows the normalized equity premium. The sample period is January 1960 to December 2017. Vertical bars denote NBER-dated recessions.
  • Figure 2: Excess market return forecasts of $E^{PLS}$ and $E^{FC}$, January 1980 to December 2017. The orange line shows the out-of-sample forecast based on $E^{PLS}$, the blue line the forecast based on $E^{FC}$, and the green line the realized excess market return. Vertical bars denote NBER-dated recessions.
  • Figure 3: Weights of $E^{PLS}$ and $E^{FC}$ on fundamental variables, January 1980 to December 2017. The figure shows time-varying PLS weights for the 16 variables (DP, DY, EP, DE, SVAR, BM, NTIS, TBL, LTY, LTR, TMS, DFY, DFR, INFL, $eRm$, $eBm$). $E^{FC}$ assigns equal weights of 6.25%. Vertical bars denote NBER-dated recessions.