The Inverted yield curve and hidden Markov models in predicting future bear markets

Turun kauppakorkeakoulu • Turku School of Economics Bachelor’s thesis x Master’s thesis Licentiate’s thesis Doctor’s thesis Subject Accounting and Finance Date 16.6. 2020 Author(s) Olli Rihko Student number Number of pages 93 + Appendices Title The Inverted yield curve and hidden Markov models in predicting future bear markets Supervisor(s) Prof. Luis Alvarez Esteban Abstract Previous studies have shown very clearly that there is a connection between the inversion of the yield curve and future recessions measured as contractions in the GDP. The focus of this study was, however, the connection between financial markets and the inverted yield curve, which has not been studied as much as the production related dependences. Although it is difficult to draw a clear line between stock market crashes and the preceding inversions of the yield curve, the data suggests that the inverted yield curve is a sign of more volatile times ahead, which clearly heightens the risk of a major stock market downturn. The empirical part of the study combined other factors and tools – hidden Markov models, credit spreads, S&P 500 returns, NY Fed recession probability model and the CAPE ratio – with the inverted yield curve in order to improve the predictability of future stock market crashes, which was then used to construct allocation strategies between the stock market and risk-free US Treasury rates. The proposed strategies managed to beat the benchmark and the conducted transaction cost sensitivity analysis proves that the strategies are feasible at reasonable transaction cost levels. The greater annualized returns and lesser volatility of the strategies lead to significantly better risk-adjusted returns than what one would achieve using the simple buy and hold strategy. The obtained Sharpe ratios range from 0,531 to 0,824, whereas the Sharpe ratio of the benchmark total US stock market return is 0,499 during the (pseudo) out-ofsample forecasting period of 1986–2019. It should be noted that the analysis is conducted using past data and the true acid test of the strategies will be made during the current inversion period. Although greater volatility leads to greater opportunities in the market, the effectiveness of the proposed strategies in this study is based on prudence and patience: the best option for the average investor could very well be to weather the storm in safer assets and then return to the stock market once the volatility of the market is lower again.Previous studies have shown very clearly that there is a connection between the inversion of the yield curve and future recessions measured as contractions in the GDP. The focus of this study was, however, the connection between financial markets and the inverted yield curve, which has not been studied as much as the production related dependences. Although it is difficult to draw a clear line between stock market crashes and the preceding inversions of the yield curve, the data suggests that the inverted yield curve is a sign of more volatile times ahead, which clearly heightens the risk of a major stock market downturn. The empirical part of the study combined other factors and tools – hidden Markov models, credit spreads, S&P 500 returns, NY Fed recession probability model and the CAPE ratio – with the inverted yield curve in order to improve the predictability of future stock market crashes, which was then used to construct allocation strategies between the stock market and risk-free US Treasury rates. The proposed strategies managed to beat the benchmark and the conducted transaction cost sensitivity analysis proves that the strategies are feasible at reasonable transaction cost levels. The greater annualized returns and lesser volatility of the strategies lead to significantly better risk-adjusted returns than what one would achieve using the simple buy and hold strategy. The obtained Sharpe ratios range from 0,531 to 0,824, whereas the Sharpe ratio of the benchmark total US stock market return is 0,499 during the (pseudo) out-ofsample forecasting period of 1986–2019. It should be noted that the analysis is conducted using past data and the true acid test of the strategies will be made during the current inversion period. Although greater volatility leads to greater opportunities in the market, the effectiveness of the proposed strategies in this study is based on prudence and patience: the best option for the average investor could very well be to weather the storm in safer assets and then return to the stock market once the volatility of the market is lower again.