Equity Risk and Return across Hidden Market Regimes

Abstract

The key to understanding the dynamics of stock markets, particularly the mechanisms of their changes, is in the concept of the market regime. It is regarded as a regular transition from one state to another. Although the market agenda is never the same, its functioning regime allows us to reveal the logic of its development. The article employs the concept of financial turbulence to identify hidden market regimes. These are revealed through the ratio of the components, which describe single changes of correlated risks and volatility. The combinations of typical and atypical variates of correlational and magnitude components of financial turbulence allowed four hidden regimes to be revealed. These were arranged by the degree of financial turbulence, conceptually analyzed and assessed from the perspective of their duration. The empirical data demonstrated ETF day trading profits for S&P 500 sectors, covering the period of January 1998–August 2020, as well as day trade profits of the Russian blue chips within the period of October 2006–February 2021. The results show a significant difference in regard to the market performance and volatility, which depend on hidden regimes. Both sample data groups demonstrated similar contemporaneous and lagged effects, which allows the prediction of volatility jumps in the periods following atypical correlations.

Keywords

• correlation surprise
• financial turbulence
• Mahalanobis distance
• hidden regimes of stock markets