An Investment Model Via Regime-Switching Economic Indicators
The Internet bubble and 2008-2009 economic crash exposed severe limitations of traditional portfolio models, especially the dependence on a static framework e.g. a constant covariance matrix. This paper develops a novel dynamic optimization model for constructing a long-short equity portfolio. A hidden Markov model captures the critical market sentiments, with expected asset returns highly dependent on the associated economic regimes. Expected equity returns are characterized by a set of eight economic factors within a regime-switching auto-regressive approach.