Detecting and exploiting regime switching ARCH dynamics in U.S. stock and bond returns

This paper investigates the presence of Markov regimes in the conditional heteroskedastic dynamics for US excess stock and bond returns. We find strong evidence in favor of a three-state models. However, persistence and predictability in the stock-bond covariance tends to be weak. We find that the three-state model outperforms a number of benchmarks in out-of-sample prediction tests concerning means, variances, and covariances. In fact, when the three-state model is used to support mean-variance portfolio selection decisions in a recursive, out-of-sample experiments, we report that it gives the best overall performance in a number of dimensions, including realized Sharpe ratios and certainty equivalent measures.