Forecasting market turbulence using regime-switching models

We propose an early warning system to timely forecast turbulence in the US stock market. In a first step, a Markov-switching model with two regimes (a calm market and a turbulent market) is developed. Based on the time series of the monthly returns of the S&P 500 price index, the corresponding filtered probabilities are successively estimated. In a second step, the turbulent phase of the model is further specified to distinguish between bullish and bearish trends. For comparison only, a Markov-switching model with three states (a calm market, a turbulent bullish market, and a turbulent bearish market) is examined as well. In a third step, logistic regression models are employed to forecast the filtered probabilities provided by the Markov-switching models. A major advantage of the presented modeling framework is the timely identification of the factors driving the different phases of the capital market. In a fourth step, the early warning system is applied to an asset management case study. The results show that explicit consideration of the models' signals yields better portfolio performance and lower portfolio risk compared to standard buy-and-hold and constant proportion portfolio insurance strategies. © 2014 Swiss Society for Financial Market Research.