Abstract: Existing methods of partitioning the market index into bull and bear
regimes do not identify market corrections or bear market rallies.
In contrast, our probabilistic model of the return distribution
allows for rich and heterogeneous intra-regime dynamics. We focus on the characteristics and dynamics of bear market rallies and bull market corrections, including, for example, the probability of transition from a bear market rally into a bull market versus back to the primary bear state. A Bayesian estimation approach accounts for parameter and regime uncertainty and provides probability statements regarding future regimes and returns.
A Value-at-Risk example illustrates the economic value of our approach.
Keywords: Markov switching, Gibbs sampling, turning points
JEL Classification: C22; C51; C52; G1