The Aligned Economic Index & The State Switching Model

• URL: http://arxiv.org/abs/2512.20460v2
• Date: Mon, 29 Dec 2025 02:59:07 GMT
• Title: The Aligned Economic Index & The State Switching Model
• Authors: Ilias Aarab,
• Abstract summary: I study U.S. stock return predictability across economic regimes and document strong evidence of time-varying expected returns.<n>I introduce a state-switching predictive regression in which the market state is defined in real time using the slope of the yield curve.<n>I propose a new aggregate predictor, the Aligned Economic Index, constructed via partial least squares (PLS)
• Score: 0.0
• License: http://creativecommons.org/licenses/by/4.0/
• Abstract: A growing empirical literature suggests that equity-premium predictability is state dependent, with much of the forecasting power concentrated around recessionary periods (Henkel et al., 2011; Dangl and Halling, 2012; Devpura et al., 2018). I study U.S. stock return predictability across economic regimes and document strong evidence of time-varying expected returns across both expansionary and contractionary states. I contribute in two ways. First, I introduce a state-switching predictive regression in which the market state is defined in real time using the slope of the yield curve. Relative to the standard one-state predictive regression, the state-switching specification increases both in-sample and out-of-sample performance for the set of popular predictors considered by Welch and Goyal (2008), improving the out-of-sample performance of most predictors in economically meaningful ways. Second, I propose a new aggregate predictor, the Aligned Economic Index, constructed via partial least squares (PLS). Under the state-switching model, the Aligned Economic Index exhibits statistically and economically significant predictive power in sample and out of sample, and it outperforms widely used benchmark predictors and alternative predictor-combination methods.

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