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Regime changes in the relationship between stock returns and the macroeconomy The presence of nonlinear influences in the relationship between stock returns and the macroeconomy is examined for six countries. The markets chosen are Canada, France, Germany, Japan, U.K. and the U.S. Nonlinearity is accounted for via regime switching using a smooth transition regression (STR) model with the world market return as the transition variable. There is evidence of nonlinearity in all countries. Results show that covariance with the world market portfolio increases during ‘crisis ’ regimes, complementing the findings of Longin and Solnik (2001). Interest rate and inflation variables are strong determinants of stock returns while evidence of the role of industrial production growth, dividend yields and oil prices is identified in individual cases. Out-of-sample forecasting of the nonlinear models is superior to a random walk but struggles to out-perform that of the linear models. However, the smooth transition regression models predict direction more frequently than linear specifications

Topics: Smooth transition, Regime switching
Year: 2011
OAI identifier: oai:CiteSeerX.psu:
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