Are Different National Stock Markets Driven by the Same Stochastic Hidden Variable?

Abstract

The following contribution analyzes linkages between preselected national stock markets by a multivariate application of Markov-Switching models. This study shows evidence that the US-stock market and the German and Swedish stock markets are driven by the same unobservable stochastic variable. The latent variable causes these stock markets to switch between highly persistent Bull- and Bear-market regimes which offer strategic market timing opportunities. An out-of-sample experiment where stock market regimes are simultaneously forecasted on a monthly frequency (January 2008 – December 2010) shows that an actively managed equity funds being restricted to hold stocks permanently, dominates all passive trading strategies that account for internationally diversified equity portfolios.