Does non-linearity help us understand, model and forecast UK stock and bond returns: evidence from the BEYR

Citation

McMillan D (2012) Does non-linearity help us understand, model and forecast UK stock and bond returns: evidence from the BEYR. International Review of Applied Economics, 26 (1), pp. 125-143. https://doi.org/10.1080/02692171.2011.580268

Abstract
The usefulness of non-linear models to provide accurate estimates and forecasts remains an open empirical debate. This paper examines the nature of the estimated relationships and forecasting power of smooth-transition models for UK stock and bond returns using a range of financial and macroeconomic variables as predictors. Notably, evidence of non-linearity is stronger when the bond-equity yield ratio is used as the transition variable. This ratio measures whether stocks are over (under)-valued relative to bonds and can act as a signal for portfolio managers. In-sample results reveal noticeable differences regarding the nature of relationships between the linear and non-linear setting, while results of a recursive forecasting exercise reveal both statistical and economic improvement over a linear model. Overall, these results support the view that non-linear estimates and forecasts can provide useful information for stock market traders, portfolio managers and policy-makers.

Keywords
STR models; forecasting; financial returns; BEYR

Journal
International Review of Applied Economics: Volume 26, Issue 1