1 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.

I ntroductI on
It is both human nature and a useful exercise to compare something of current interest
to past experience, offering potentially valuable insights as we attempt to anticipate and
adjust to an uncertain future. In economics, practitioners often seek to characterize
different time periods and environments as regimes, thereby facilitating side-by-side
analysis.
During the second half of the 1990s, for example, the U.S. economy was experiencing
robust economic growth without igniting inflationary pressure, while the unemployment
rate remained low. This period was often compared to the 1960s, and was characterized
as a Goldilocks economic regime: not too hot, nor too cold, but just right. Fast forward
to the past year, and the question often asked (for example by Krugman (2008)) was,
Are we going back to the 1930s? Depression is clearly considered as a regime. As more
aggressive quantitative easing action was taken, some started to wonder if we would see
a return to the stagflation of the 1970s, during which both inflation and economic
stagnation occurred simultaneously yet another possible regime.
In characterizing the state of the economy, growth and prices are by far the most widely
followed metrics. For example, periods of widespread economic growth are called
expansions, while periods of broad contraction are called recessions. Similarly, periods
of rising prices are called inflationary, while periods of declining prices are referred to
as deflationary. However, at least in the United States, the definition of a recession is far
more complicated and widely debated than just using the economic growth metric. It is
generally agreed that the National Bureau of Economic Research (NBER) has become
the authority in dating the turning point at which the U.S. economy has moved from
expansion to recession and vice versa. As described in NBERs Web site and discussed at
length in Chauvet and Piger (2008), the number of variables considered by the NBERs
Business Cycle Dating Committee far exceeds economic growth alone. Unfortunately,
many observers believe that this process is neither transparent nor reproducible.
The practice of categorizing individual time periods with economic regimes
such as recession, depression and expansion is commonplace and has a strong
influence on the return assumptions employed as inputs in asset allocation models.
Unfortunately, methodologies used to determine whether a period belongs to
a given regime vary in their effectiveness and can be inexact. In this paper, we
offer an alternative, nonparametric approach that includes emphasizing current
conditions rather than preset regime characteristics and drawing on probabilities
to reflect the reality that no two economic periods are identical. We also include
case studies to illustrate and apply our recommendations, which we believe are a
valuable addition to current literature on the subject of economic regimes.
Hakan Kaya, Ph.D.
Quantitative Investment Group
Neuberger Berman
Wai Lee, Ph.D.
Managing Director
Quantitative Investment Group
Neuberger Berman
Bobby Pornrojnangkool, Ph.D.
Senior Vice President
Quantitative Investment Group
Neuberger Berman
August 2009
Regimes: Nonparametric
Identification and Forecasting
Forthcoming in Journal of Portfolio Management Winter 2010
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
2 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
Of course, NBER is not the only authority on characterizing economic conditions. Some
economists pair up the two measures, growth and prices, to generate four phases of the
economy, such as expansion with rising inflation, recession with falling inflation, and the
like. Strongin, Petsch and Fenton (1997) divide the economy, entirely based on growth, in
two ways: (1) above and below capacity and (2) rising above or falling below sustainable
growth rates, such that a particular state of economy can be mapped into one of the four
phases:
Phase 1: below potential and falling
Phase 2: below potential and rising
Phase 3: above potential and rising
Phase 4: above potential and falling
While this classification provides an intuitive and appealing conceptual framework, its
implementation is challenging and prompts some reservations regarding the resulting
inferences and conclusions. To name one obstacle it requires estimates of potential or
sustainable growth rate which is subject to debate. Furthermore, as the authors note,
the key analytical issue is dating the transitions between phases, especially in periods
during which the economy appears to be in an up-and-down range rather than on a
distinguishable path. In this way, the framework can remain as subjective as it is objective
and analytical.
An important mandate of the investment industry is to make prudent investment
decisions for clients. The analysis of regime switching, however, typically starts with
dissecting and predefining the world in regimes such as those discussed in Strongin,
Petsch and Fenton (1997). As such, the industry starts with history, then attempts to
map the current period of interest into predefined historical regimes in order to generate
return and risk forecasts to serve as inputs in making investment decisions. Based on our
experience and observations in the industry, the majority of mapping is done through a
combination of largely subjective visual inspection of charts, which is supplemented by
simple order statistics. Nevertheless, borrowing terminology from economic theory, we
consider the investment industrys approach to regime switching to be structural, as it
offers more insights into phases of the economy.
The concept of regimes has been part of mainstream financial theory for more than half
of a century. The key financial security in a general equilibrium setting for the financial
economy is a state-contingent claim, or what is commonly known as the Arrow-Debreu
security. An Arrow-Debreu security pays one dollar if a particular state or regime of the
world occurs at a particular point in time, and otherwise pays nothing. With a set of pre-
defined regimes, probabilities of the regimes occurrence, and discount rates, it is not
difficult to see that any financial security, traditional or derivative, with uncertain future
payoffs that are conditional on the regimes, can be created and priced as a portfolio of
Arrow-Debreu securities. As a result, Arrow-Debreu securities are fundamental building
blocks in asset pricing theory. It can be shown that an economy with all regimes spanned
by Arrow-Debreu securities will rule out any arbitrage opportunity, and the resulting
market is said to be complete. While the theory of market completeness is sound,
academias take on Arrow-Debreu securities remains largely theoretical. For more details,
see Ingersoll (1987) and Merton (1994). For information on the feasibility and synthetic
creation of these securities, see Chapter 16 in Merton (1994).
The key analytical issue is
dating the transitions between
phases, especially in periods
during which the economy
appears to be in an up-and-
down range rather than on a
distinguishable path.
Based on our experience and
observations in the industry,
the majority of mapping is
done through a combination
of largely subjective visual
inspection of charts, which
is supplemented by simple
order statistics.
The key financial security in
a general equilibrium setting
for the financial economy is a
state-contingent claim, or what
is commonly known as the
Arrow-Debreu security.
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
3 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
Much of the academic literature focusing on the empirical implementation of regime
switching models has been driven by econometrics. Among the most widely cited studies
is the seminal work of Hamilton (1989). In general, studies following this direction
relate or define regimes as statistical distributions. For example, Ang and Bekaert (2004)
characterize regimes based on episodes of high volatility and unusually high correlations
among international equity markets. Transition probabilities from one regime to another
are then estimated and the resulting investment opportunity set that is conditional
on regimes is then used as inputs to portfolio optimization in deriving optimal asset
allocation decisions. The more recent study by Guidolin and Timmermann (2008) finds
evidence that joint distribution of stock and bond returns can be characterized by four
regimes: crash, slow growth, bull and recovery. Tu (2008) further demonstrates in a
similar bull/bear Markov switching regime analysis that portfolio decisions in a model
that ignores regime switching can result in substantial losses.
It is interesting to note that the academic approach to regime switching is primarily
investment driven, focusing on optimal portfolio weights based on estimated transition
probabilities among regimes and the resulting expected returns and risk measures. As
these regime-switching asset allocation models do not explicitly focus on the structure of
the economy, we consider such empirical work to provide reduced form models.
As we move further away from 2008 arguably the most dramatic and challenging year
ever for living investors enduring a global recession, the topic of regime switching
remains timely. This paper adds to the literature on several fronts. As discussed above,
the existing works from both the industry and academia on regime switching start with a
predefined set of regimes and then map the current period of interests into one of those
choices. In this paper, we reverse the order of this process, so that the current period
of interests, instead of the predefined regimes from history, becomes the focal point. In
addition, we argue that every period in history is unique no two are identical. As a
result, regime identification should be probabilistic, so that each historical period can
be assigned a probability of being in the same regime with the current period of interest.
To some extent, the academic approach of estimating transition probabilities from
one regime to another is consistent with our view that this should be approached as a
statistical problem.
To that end, we first start with the current period of interests and try to look back in history
to identify periods that are probabilistically close to the current period. In doing so, we first
briefly review the technique called Locally Weighted Scatter Plot Smoothing (LOWESS),
commonly known as Locally Weighted Regression and studied under nonparametric
methods (Hrdle (1994)). We present several case studies with different sets of what
we call regime identifiers. In the first case, we use inflation and growth as identifiers.
Through LOWESS, we report the 10 historical periods that have the highest probability
of being the closest neighbor to the year 2008. Subsequent inflation and growth of these
periods are then analyzed, and can be used as forecasts of subsequent economic activities.
In the second case, we introduce asset returns (such as for stocks) as identifiers. If capital
markets are forward-looking, we can argue that including asset returns as identifiers will
better incorporate market expectations for some macroeconomic identifiers. In the third
and last case, we demonstrate how to turn our approach into a regime-forecasting tool;
for example, by using a set of variables believed to be considered by NBER in defining
turning points, we make dating turning points into a repeatable process.
Existing works from both the
industry and academia on
regime switching start with a
predefined set of regimes and
then map the current period
of interests. We reverse the
order of this process, so that
the current period of interests,
instead of the predefined
regimes from history, becomes
the focal point.
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
4 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
LocaLLy WeI ghted scat ter pLot smoothI ng ( LoWess)
LOWESS is a local polynomial kernel method developed by Cleveland (1979 and 1988)
that robustly fits smoothing functions to data without any assumptions about the form
or the shape of these functions. This is achieved by employing lower-order polynomial
approximation in a close neighborhood of a point of concern x, where data points that are
closer to x are given more importance according to their distance. In our case studies, this
explanatory vector x contains macro factors such as inflation and growth that summarize
the snapshot of the economy during a particular period of time.
The response, or dependent variable of interest, denoted by y, can be a measure of future
macro variables or market returns. In our case studies, y includes inflation, growth and
stock returns, among others. Given n observations of y
i
(i = 1n) and k dimensional
independent variables x
i
= (x
i1
,,x
ik
)

(i = 1n) in the neighborhood of a point x, the aim
is to find the coefficients of a p
th
order polynomial P by minimizing
where w(x
i
,x)

is the weight given to the i
th
closest neighbor. Here the weight function is
defined with respect to the n
th
nearest neighbor: Let (x,x
i
) denote the distance of x
i
to x,
and let d(x) denote the distance of n
th
nearest x
i
to x, then we have
A lower-order polynomial is desired in order not to introduce variance, especially at
boundaries. To keep the analysis simple and transparent, in all of our examples we employ
0
th
order polynomials. In other words, the regression estimate boils down to taking the
weighted average of the n nearest response variables in the neighborhood.
The distance function (x,x
i
) can be chosen in a variety of ways. If independent variables
are categorical (such as deciles, high/low, etc.) then the city block distance can be intuitive.
Otherwise, Euclidean norm can be a sensible choice. More complex distance measures (for
example, Mahalanobis measure) can provide additional benefits such as taking into account
the covariance between explanatory variables at the expense of introducing additional
parameters. In these cases, it may be suggested that a robust principal component analysis
is carried out, and data are projected onto the first few principal components, which can
then be used as orthogonal explanatory variables. Principal components can also be useful
as a tool to reduce the dimension of the design space.
Another important point is the proper scaling of data. In a multivariate analysis, when
we have independent variables in different scales, we first need to scale the data before
applying any distance measure. To this end, one can either normalize the observations
by subtracting their means and dividing by their standard deviation, or by transforming
the data to the unit interval by either scaling them with their range or by calculating their
empirical percentile levels. In our examples, we followed the latter approach.
Another benefit of this framework is that a priori relative ranking of factors is possible.
To this end, when measuring distances between points, one can introduce weights,
l,
, for
LOWESS is a local polynomial
kernel method developed by
Cleveland (1979 and 1988)
that robustly fits smoothing
functions to data without any
assumptions about the form or
the shape of these functions.

2
1
) , ; ( ) , (
Min

n
i
i i i
p x P y x x w B
B
( )

(
(
,
\
,
,
(
j

otherwise 0
) 1 , 0 [ 1
) (
) (
) , (
) , (
3
3
u u
u K
x d
x x
K x x w
i
i
p
Another important point is
the proper scaling of data. In
a multivariate analysis, when
we have independent variables
in different scales, we first
need to scale the data before
applying any distance measure.
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
5 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
each independent variable. In the Euclidian case, the distance function between points
x = (x
1
,,x
k
) and z = (z
1
,,z
k
) can be represented as
For example, if the analyst believes market returns track inflation more effectively, then
he/she can give more weight to market variables relative to other independent factors. If
no ranking preference is present among indicators, s can be set to 1 to recover the usual
Euclidian measure.
data set
Our analysis requires a substantial time series of financial and macroeconomic data.
This is necessary because regimes, depending on their definition, may last from a few
months to a decade or more, and the longer they get, the fewer data points we have for
analysis. Due to this limitation, we ruled out a number of macroeconomic indicators
such as manufacturing and trade inventories and sales, and personal income less transfer
payments, which appear in NBERs Web site as turning point identifiers.
We compiled data on inflation, industrial production, S&P 500 total returns, nonfarm
payrolls and corporate and long-term government bonds. Our S&P 500 and long-term
corporate and government bond monthly total returns are from the period of January
1926 through May 2009
1
. Inflation, industrial production and nonfarm payrolls data
were obtained from the St. Louis FRED database: Consumer Price Index year-over-
year percentage change for all urban consumers (January 1913 May 2009)
2
; Industrial
Production Index year-over-year percentage change (January 1919 May 2009)
3
;
Nonfarm Payrolls Index year-over-year percentage change (January 1939 May 2009)
4
.
The frequency of the raw data is monthly. However, in order to capture regimes, we
aggregate data to an annual frequency, creating monthly overlapping time series of annual
geometric returns of S&P 500 and government bonds, and calculating year-over-year
changes in the trend-restored CPI, industrial production, and nonfarm payrolls data.
I mpLementatI on
Let us denote by the vector x
T
the current state of the economy. We first calculate the
weighted distances of each monthly state vector x
t
(t = 1,2,,T-1) to x
T
and rank them
in ascending order. The distances, as denoted by (x
T
,x
t
), are measured in scaled data
(percentiles) as described above. Because we do not have a priori preference for an
economic variable, we always equally weight the components of x
t
when measuring the
distances to x
T
.
Second, we apply a filter to rule out periods that follow each other. If a period ending at
time t is selected, any other periods ending in t 3 years are dropped from the ranked
data to ensure periods belonging to the same regime do not overwhelm the neighborhood
during local regression. This way, we always maintain at least two years between selected
yearly periods.
1
Source: Ibbotson Associates
2
Source: Board of Governors of the Federal Reserve System (CPIAUCNS)
3
Source: U.S. Department of Labors Bureau of Labor Statistics (INDPRO)
4
Source: Bureau of Labor Statistics (PAYEMS)

k
l
l l l
z x v z x
1
2
) , ( R
Our analysis requires a
substantial time series of
financial and macroeconomic
data, because regimes may
last from a few months to
a decade or more.
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
6 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
Having compiled a neighborhood consisting of 10 nearest periods, we then analyze what
happened subsequently. For example, if the year 1930 is the period that most resembles
the current period, 2008, we will be interested in knowing what happened during the
one-to-three-year period after 1930. Did the inflation increase/decrease or were there
corrections in the stock/bond market afterward? We calculate these types of consequent
macroeconomic states, and then run weighted regressions for each of these returns or
identifiers. Here, the weights are assigned by the tricube kernel and can be thought of as
the reoccurrence probability of the associated regime.
These weights can also be used to calculate recession probabilities. For instance, if, in the
neighborhood, there are a number of periods associated by NBER with a recession, then
the sum of the weights of these recession periods gives us the recession probability for the
current environment.
Below we exhibit our results in three cases. First, we will use inflation and industrial
production as regime identifiers. Next, we will add asset returns to the analysis, and
finally include nonfarm payroll enrollment to proxy NBERs analysis.
case 1: Inflation and growth as regime Identifiers
What defines a regime? If we choose to answer this question in a macroeconomic context,
then typically the usual suspects are inflation and growth. Payrolls, wages, trades, sales,
inventories and many other variables possibly correlate and/or integrate in inflation and
growth in low frequencies, thus giving us grounds to simply define a regime with respect
to these two indicators.
The question we would like to answer is how the year 2008 compares to previous periods
in history in terms of inflation and industrial production growth. The shaded section
in Table 1, on the following page, shows the year-over-year percentage changes in CPI
and in industrial production. It also has the associated percentiles for the actual values.
For example, a 0.09% year-over-year increase in CPI corresponds to the 14th percentile.
Similarly -8.86% year-over-year industrial production growth corresponds to the 8th
percentile. These two measures, both in actual and in percentile units, tell us that 2008,
although not the worst, is one of the worst years in history.
Table 1 also lists 10 periods in history that are closest to 2008 with respect to a weighted
Euclidean measure of component percentiles. Here, we equally weighted these indicators
when calculating distances. As a result, for example, the period from July 1953 to July
1954 resembles 2008 the most. We also note that there was a recession between July 1953
and May 1954 which partly covers this similar period.
Table 1 further provides us with the tricube kernel-driven probabilities assigned to each
of these 10 periods. The first two periods are given almost the same probabilities (13.1%),
and these probability measures decrease as periods become less similar (0.14% for the
10th closest neighbor).
As discussed on the prior page, we can also define a recession measure by simply summing
the probabilities assigned to recession periods. In Table 1, nine out of 10 similar periods
correspond to recessions. The sum of probabilities of these periods equals 96%.
What defines a regime? In a
macroeconomic context, the
usual suspects are inflation
and growth.
The question we would like to
answer is how the year 2008
compares to previous periods
in history in terms of inflation
and industrial production
growth.
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
7 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
Source: Quantitative Investment Group. For illustrative purposes only.
Having identified the similar periods, we may be interested in what happened as a
consequence of these periods. Table 2 tabulates the annualized geometric returns of stock
and bond markets and annualized changes in the CPI and the industrial production in
the subsequent one to three years. For example, after the July 1953 July 1954 period, S&P
500 returned 47.35% next year, and 20.58% annualized in the next three years. Similarly,
CPI decreased 0.37% in the next year and increased at an annualized mean rate of 1.71%
in the next three years. In this same period, the industrial production clearly reverted
to the mean by achieving 14.56% and 6.68% annualized mean rates in the next one-to-
three-years.
Table 2 also shows the summary statistics of the market returns and regime identifiers.
Each column in the probability-weighted average row shows the estimate of a weighted
polynomial regression of order 0 with kernel calculated weights. In other words, this
regression is equivalent to taking the weighted average of the respective column.
For example, the regression estimate for the yearly S&P 500 return can be read as 19.87%.
Its associated standard error is 31.41%. For comparison purposes, this table also lists the
historical (grand) minimum, maximum and average of each column, calculated using
periods that are not included in these 10 similar periods. It is clear that when compared
to these averages, the model is pointing to higher-than-expected stock returns and lower-
than-expected government bond returns in the year after 2008. Furthermore, lower-than-
expected CPI growth and higher-than-expected industrial production are predicted.
tabLe 1: regI me I dentI fI ers of current Versus cLosest recessI on
perI ods
Regime Regime Identifers:
Weight % 50% 50%
Rank Probability Start Date End Date
CPI
Actual %
CPI
Percentile
INDPRO
Actual %
INDPRO
Percentile Recession Periods
Current Dec-07 Dec-08 0.09 14.24 -8.86 8.48
1 13.10 Jul-53 Jul-54 0.37 15.15 -8.56 8.69 Jul 1953 to May 1954
2 13.10 Jan-29 Jan-30 0.00 14.04 -7.17 10.61 Aug 1929 to Mar 1933
3 13.07 May-48 May-49 -0.42 11.82 -6.88 11.01 Nov 1948 to Oct 1949
4 12.81 Jan-37 Jan-38 0.71 17.27 -26.09 2.12 May 1937 to Jun 1938
5 12.29 Apr-60 Apr-61 1.01 20.61 -3.65 16.06 Feb 1960 to Feb 1961
6 12.16 Jan-01 Jan-02 1.14 22.32 -4.16 15.05 Mar 2001 to Nov 2001
7 11.45 Jan-32 Jan-33 -10.30 1.72 -11.31 6.87 Aug 1929 to Mar 1933
8 8.25 Apr-44 Apr-45 1.70 32.12 -4.98 13.94 Feb 1945 to Oct 1945
9 3.64 May-85 May-86 1.48 28.79 0.56 28.99
10 0.14 Dec-25 Dec-26 -1.12 9.09 2.47 41.01 Oct 1926 to Nov 1927
Probability of Recession 96.40%
It is clear that when compared
to these averages, the model
is pointing to higher-than-
expected stock returns
and lower-than-expected
government bond returns
in the year after 2008.
Furthermore, lower-than-
expected CPI growth and
higher-than-expected industrial
production are predicted.
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
8 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
Source: Quantitative Investment Group. The historical performance shown is for illustrative purposes and is not meant to forecast,
imply or guarantee future performance.
In Figure 1, we plot the time series of estimated recession probabilities. For each month
starting in 1972, we rerun the model using data up until that month and calculate the
neighboring weights. The sum of the weights of the neighbors, which are associated
with recession periods, are then defined to be that months recession probability. In this
figure, the height of the bars represents recession probability and shaded areas show the
NBER defined recession periods. We have also placed up and down arrows at NBER
announcement dates regarding peaks and troughs, respectively.
Figure 1 shows that, although not perfectly matching the NBER dates, the recession
probabilities calculated as above rises over 50% and decreases below 50% before
announcement dates. We also see that, especially in the mid-1980s, there are two periods
in which the model gives false alarms.
tabLe 2: cLosest regI mes and subsequent market and economI c
enVI ronment
Regime % Annualized Returns % Annualized Regime Identifers
S&P 500 Corp Bond Gov Bond CPI INDPRO
Rank Prob % Start Date End Date 1 Year 3 Years 1 Year 3 Years 1 Year 3 Years 1 Year 3 Years 1 Year 3 Years
Current Dec-07 Dec-08
1 13.10 Jul-53 Jul-54 47.35 20.58 0.40 -2.50 -3.36 -2.75 -0.37 1.68 14.56 6.68
2 13.10 Jan-29 Jan-30 -25.86 -28.19 9.52 7.19 3.97 5.72 -7.28 -9.41 -21.24 -16.83
3 13.07 May-48 May-49 42.41 27.64 2.34 1.12 4.29 0.94 -0.42 3.38 13.97 8.39
4 12.81 Jan-37 Jan-38 20.47 3.44 5.96 4.38 5.53 4.94 -1.42 -0.24 18.55 18.96
5 12.29 Apr-60 Apr-61 2.91 10.25 7.08 4.64 3.55 2.61 1.33 1.21 11.26 7.76
6 12.16 Jan-01 Jan-02 -23.02 3.24 14.57 10.38 15.01 9.63 2.56 2.47 2.71 2.60
7 11.45 Jan-32 Jan-33 68.96 33.33 7.34 9.60 1.00 4.58 2.30 2.25 25.50 17.71
8 8.25 Apr-44 Apr-45 31.74 6.38 4.02 1.31 5.84 1.70 3.32 9.53 -26.23 -3.63
9 3.64 May-85 May-86 21.12 12.78 5.70 9.21 5.49 8.08 3.78 4.27 4.62 3.86
10 0.14 Dec-25 Dec-26 37.48 21.83 7.44 4.50 8.94 4.08 -2.29 -0.96 -4.82 1.32
Prob Weighted Average 19.87 9.55 6.40 4.70 4.42 3.60 -0.09 1.04 5.96 5.33
Average 22.35 11.13 6.44 4.98 5.03 3.95 0.15 1.42 3.89 4.68
Median 26.43 11.52 6.52 4.57 4.89 4.33 0.48 1.96 7.94 5.27
Max 68.96 33.33 14.57 10.38 15.01 9.63 3.78 9.53 25.50 18.96
Min -25.86 -28.19 0.40 -2.50 -3.36 -2.75 -7.28 -9.41 -26.23 -16.83
Prob Weighted Stdev 31.41 17.92 4.12 4.20 4.84 3.56 3.21 4.69 16.41 10.74
Stdev 30.34 17.20 3.91 4.19 4.79 3.57 3.32 4.78 16.89 10.27
Grand Average 12.06 10.69 6.08 5.93 5.86 5.55 3.03 3.11 3.82 3.55
Grand Min -67.57 -42.35 -18.17 -6.90 -17.10 -6.03 -11.36 -9.99 -33.66 -22.56
Grand Max 162.88 43.34 46.74 23.85 54.41 25.42 17.96 11.25 62.04 25.39
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
9 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
Source: Quantitative Investment Group. For illustrative purposes only.
case 2: Inflation, growth and asset returns as regime Identifiers
Some may argue that because markets are forward-looking, they discount back all
relevant information about the future state of the economy. Therefore, we can expect
that prices or returns can identify the current regime, and hence can be used for tracking
macroeconomic variables.
In what follows, we rerun the same analysis as in Case 1 but now with the addition of
market return data. Here, one can employ a number of assets, or use a portfolio of assets,
such as a 60/40 stock/bond mix, as an identifier. Volatility and/or correlation figures can
also be related to regimes.
Instead of speculating with regard to what constitutes the best identifier, we simply use
yearly S&P 500 total returns as the additional identifier in this section. We avoid the bonds
due to their dependence on political agendas. For example, during the Reagan years of
the mid-1980s, we experienced high bond returns as a result of a program to alleviate the
pain of the early-80s recessions.
In Table 3, we see that most of the recessionary periods picked by the model overlap with
the ones in Table 1. Although, in this case, we have eight recession periods (compared to
ten in Table 1), the recession probability increases to 99.6%.
Some may argue that because
markets are forward looking,
they discount back all relevant
information about the
future state of the economy.
Therefore, we can expect that
prices or returns can identify
the current regime, and hence
can be used for tracking
macroeconomic variables.
fI gure 1: recessI on probabI LI tI es WI th I dentI fI ers cpI and
I ndustrI aL productI on
0.0
0.2
0.4
0.6
0.8
1.0
Aug-09 Jun-05 Jun-01 Jun-97 Jun-93 Jun-89 Jun-85 Jun-81 Jun-77 Jun-73
Recession Probability
NBER Recession Periods
Dec 2007 Peak
Nov 2001 Trough
Mar 2001 Peak
Mar 1991 Trough
Jul 1990 Peak
Nov 1982 Trough
Jul 1981 Peak
Jul 1980 Trough
Jan 1980 Peak
CPI Y-o-Y Ch 50.00
INDPRO Y-o-Y 50.00
Identifier Weight (%)
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
10 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
Source: Quantitative Investment Group. For illustrative purposes only.
Did the inclusion of S&P 500 change the forecasts? Table 4 shows that, although in
absolute amounts the forecasts measured by probability-weighted average changed, the
direction did not change. The model still predicts a mean reversion in S&P 500 returns
and underperformance in government bond returns. Corporate bond returns are very
much in line with historical averages. On the macro side, we can see from Table 4 that a
low CPI growth rate of 0.07% is predicted, compared to a higher-than-average industrial
production growth rate.
Source: Quantitative Investment Group. The historical performance shown is for illustrative purposes and is not meant to forecast,
imply or guarantee future performance.
tabLe 3: regI me I dentI fI ers of current Versus cLosest recessI on
perI ods
Regime Regime Identifers:
Weight % 33% 33% 33%
Rank Probability Start Date End Date
S&P 500
Actual %
S&P 500
Percentile
CPI
Actual %
CPI
Percentile
INDPRO
Actual %
INDPRO
Percentile Recession Periods
Current Dec-07 Dec-08 -37.00 2.02 0.09 14.24 -8.86 8.48
1 22.60 Nov-31 Nov-32 -25.27 4.44 -10.76 0.91 -10.92 7.47 Aug 1929 to Mar 1933
2 20.58 Oct-00 Oct-01 -24.89 4.65 2.10 37.47 -5.23 13.64 Mar 2001 to Nov 2001
3 17.93 Dec-59 Dec-60 0.46 27.58 1.35 26.16 -6.16 11.92 Feb 1960 to Feb 1961
4 14.24 Aug-37 Aug-38 -20.05 6.67 -2.80 5.15 -23.13 2.53 May 1937 to Jun 1938
5 9.92 Jun-48 Jun-49 -9.48 14.75 -0.83 9.29 -8.26 9.29 Nov 1948 to Oct 1949
6 5.58 Feb-53 Feb-54 7.14 38.48 1.50 28.89 -6.00 12.53 Jul 1953 to May 1954
7 5.20 Dec-56 Dec-57 -10.79 13.23 2.86 51.21 -6.83 11.11 Aug 1957 to Apr 1958
8 3.60 Nov-28 Nov-29 -10.48 13.64 0.58 16.26 0.37 27.68 Aug 1929 to Mar 1933
9 0.29 Jul-92 Jul-93 8.67 41.52 2.74 48.59 2.25 39.60
10 0.06 Sep-97 Sep-98 9.06 42.42 1.48 28.69 4.60 55.05
Probability of Recession 99.60%
Did the inclusion of S&P 500
change the forecasts? In
absolute amounts the forecasts
measured by probability
weighted average changed,
direction did not change.
tabLe 4: cLosest regI mes and subsequent market and economI c
enVI ronment
Regime % Annualized Returns: % Annualized Regime Identifers
S&P 500 Corp Bond Gov Bond CPI INDPRO
Rank Prob % Start Date End Date 1 Year 3 Years 1 Year 3 Years 1 Year 3 Years 1 Year 3 Years 1 Year 3 Years
Current Dec-07 Dec-08
1 22.60 Nov-31 Nov-32 58.66 31.57 9.11 11.47 2.40 5.11 0.00 1.48 16.13 16.33
2 20.58 Oct-00 Oct-01 -15.11 3.91 8.06 8.80 6.21 6.62 2.01 2.39 2.03 2.13
3 17.93 Dec-59 Dec-60 26.89 12.45 4.82 4.96 0.97 2.99 0.67 1.21 12.53 7.56
4 14.24 Aug-37 Aug-38 -2.93 0.60 1.97 4.59 6.16 5.16 -2.15 1.78 19.07 21.85
5 9.92 Jun-48 Jun-49 34.42 29.64 1.72 0.89 2.32 0.40 -0.42 3.38 17.60 8.12
6 5.58 Feb-53 Feb-54 47.52 23.35 0.45 -0.55 0.45 0.09 -0.75 0.96 7.72 6.97
7 5.20 Dec-56 Dec-57 43.37 17.27 -2.22 1.84 -6.11 1.45 1.75 1.60 5.37 2.47
8 3.60 Nov-28 Nov-29 -16.91 -27.56 11.05 5.69 4.44 4.24 -5.34 -9.05 -22.51 -16.99
9 0.29 Jul-92 Jul-93 5.19 15.62 -1.62 5.46 -3.00 5.14 2.73 2.79 5.63 4.94
10 0.06 Sep-97 Sep-98 27.79 2.04 -5.92 4.72 -8.32 4.87 2.59 2.87 3.70 0.99
Prob Weighted Average 22.30 14.45 5.33 6.32 2.96 4.08 0.05 1.45 10.69 9.32
Average 20.89 10.89 2.74 4.79 0.55 3.61 0.11 0.94 6.73 5.44
Median 27.34 14.03 1.85 4.84 1.65 4.55 0.33 1.69 6.67 5.96
Max 58.66 31.57 11.05 11.47 6.21 6.62 2.73 3.38 19.07 21.85
Min -16.91 -27.56 -5.92 -0.55 -8.32 0.09 -5.34 -9.05 -22.51 -16.99
Prob Weighted Stdev 28.47 14.44 3.66 3.83 3.06 2.13 1.68 2.14 8.90 8.52
Stdev 26.76 17.36 5.45 3.57 4.96 2.26 2.48 3.60 11.94 10.25
Grand Average 12.06 10.69 6.08 5.93 5.86 5.55 3.03 3.11 3.82 3.55
Grand Min -67.57 -42.35 -18.17 -6.90 -17.10 -6.03 -11.36 -9.99 -33.66 -22.56
Grand Max 162.88 43.34 46.74 23.85 54.41 25.42 17.96 11.25 62.04 25.39
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
11 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
Source: Quantitative Investment Group. For illustrative purposes only.
Figure 2 above replicates Figure 1 with the addition of S&P 500 returns as an identifier.
We can observe that with S&P 500 returns, the model aligns better with the starts and
ends of NBER recessions. However, although diminished in size, the mid-1980s false
alarm still persists.
Because returns introduce more volatility, Figure 2 is more rugged than Figure 1. However,
one can apply a few months moving average to smooth the probability data. By this way,
while still keeping correct identifications in NBER recession periods, one can remove the
false alarms in mid-1980s and mid-1990s.
case 3: quantifying the nber turning points dating process
According to NBERs Web site, one of the indicators watched in dating business cycles is
nonfarm payrolls data, which consist of the total number of paid U.S. workers (excluding
employees involved in farming-related areas). Because of their political implications,
such data can be linked to the Federal Reserves actions on interest rates: On one hand,
an increase in these data means rising employment, which may result in higher inflation
and, hence, increases in interest rates. On the other hand, a decrease may suggest a route
towards recession and lead to possible interest rate cuts.
In Table 5, we list the 10 neighboring regimes closest to 2008. Because the nonfarm
payroll data started in 1940, earlier years have been dropped from the analysis. Even with
the exclusion of the Great Depression and other recessionary periods in the 1920s and
fI gure 2: recessI on probabI LI tI es I dentI fI ers cpI , I ndustrI aL
productI on and s&p 500
0.0
0.2
0.4
0.6
0.8
1.0
Aug-09 Jun-05 Jun-01 Jun-97 Jun-93 Jun-89 Jun-85 Jun-81 Jun-77 Jun-73
Recession Probability
NBER Recession Periods
Dec 2007 Peak
Nov 2001 Trough
Mar 2001 Peak
Mar 1991 Trough
Jul 1990 Peak
Nov 1982 Trough
Jul 1981 Peak
Jul 1980 Trough
Jan 1980 Peak
S&P 500 Year 33.33
CPI Y-o-Y Ch 33.33
INDPRO Y-o-Y 33.33
Identifier Weight (%)
According to NBER, one of the
indicators watched in dating
business cycles is nonfarm
payrolls data.
An increase in these data
means rising employment,
which may result in higher
inflation and, hence, increases
in interest rates. On the other
hand, a decrease may suggest
a route towards recession and
lead to possible interest rate
cuts.
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
12 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
30s, the model finds many other recessionary periods, leading to a recession probability
for 2008 that is quite high.
Source: Quantitative Investment Group. For illustrative purposes only.
Table 6 confirms that our projection for outperformance in stocks and underperformance
in government bonds remain the case. Again, CPI growth is predicted to be near zero
for 2009 and industrial production is expected to grow at an above-average rate. The
included nonfarm payroll growth rate is below normal for the 2009 and about normal for
the next three years.
Source: Quantitative Investment Group. The historical performance shown is for illustrative purposes and is not meant to forecast,
imply or guarantee future performance.
tabLe 5: regI me I dentI fI ers of current Versus cLosest
Regime Regime Identifers:
Weight % 25% 25% 25% 25%
Rank
Prob
% Start Date End Date
S&P 500
Actual
S&P 500
Percentile
CPI
Actual
CPI
Percentile
INDPRO
Actual
INDPRO
Percentile
NONFARM
Actual
NONFARM
Percentile Recession Periods
Current Dec-07 Dec-08 -37.00 0.72 0.09 4.44 -8.86 3.96 -2.20 6.48
1 21.29 Jun-48 Jun-49 -9.48 11.64 -0.83 1.44 -8.26 4.80 -2.90 3.72 Nov 1948 to Oct 1949
2 21.25 Jan-01 Jan-02 -16.14 4.44 1.14 12.97 -4.16 10.92 -1.40 10.92 Mar 2001 to Nov 2001
3 19.77 Dec-52 Dec-53 -0.98 22.93 0.75 8.64 -4.78 9.96 -0.90 14.17 Jul 1953 to May 1954
4 18.75 Dec-59 Dec-60 0.46 25.09 1.35 17.29 -6.16 7.68 -0.80 14.65 Feb 1960 to Feb 1961
5 13.96 Dec-56 Dec-57 -10.79 10.20 2.86 44.54 -6.83 6.72 -1.00 13.57 Aug 1957 to Apr 1958
6 3.85 Oct-43 Oct-44 13.02 51.26 1.71 24.37 1.64 34.09 -2.30 6.24
7 0.62 Aug-91 Aug-92 7.95 38.54 3.10 49.70 2.57 40.94 0.60 26.77
8 0.43 Aug-69 Aug-70 -11.39 9.12 5.26 75.87 -3.83 11.52 -0.10 20.77 Dec 1969 to Dec 1970
9 0.07 Jul-81 Jul-82 -13.39 6.12 6.24 81.87 -6.37 7.32 -2.30 6.24 Jul 1981 to Nov 1982
10 0.02 Dec-85 Dec-86 18.47 64.59 1.09 11.76 1.45 32.17 1.90 43.10
Probability of Recession 96%
tabLe 6: cLosest regI mes and subsequent market and economI c
enVI ronment
Regime % Annualized Returns: % Annualized Regime Identifers:
S&P 500 Corp Bond Gov Bond CPI INDPRO NONFARM
Rank Probability Start Date End Date 1 Year 3 Years 1 Year 3 Years 1 Year 3 Years 1 Year 3 Years 1 Year 3 Years 1 Year 3 Years
Current Dec-07 Dec-08
1 21.29 Jun-48 Jun-49 34.42 29.64 1.72 0.89 2.32 0.40 -0.42 3.38 17.60 8.12 3.10 3.37
2 21.25 Jan-01 Jan-02 -23.02 3.24 14.57 10.38 15.01 9.63 2.56 2.47 2.71 2.60 -0.20 0.50
3 19.77 Dec-52 Dec-53 52.62 28.85 5.39 -0.44 7.18 -0.04 -0.75 0.84 3.54 6.60 -0.70 2.14
4 18.75 Dec-59 Dec-60 26.89 12.45 4.82 4.96 0.97 2.99 0.67 1.21 12.53 7.56 2.10 2.20
5 13.96 Dec-56 Dec-57 43.37 17.27 -2.22 1.84 -6.11 1.45 1.75 1.60 5.37 2.47 -0.60 0.84
6 3.85 Oct-43 Oct-44 36.35 11.49 4.41 2.03 7.99 4.01 2.23 8.62 -30.76 -5.68 -7.50 2.10
7 0.62 Aug-91 Aug-92 15.14 13.82 16.22 8.64 22.79 10.06 2.73 2.72 2.78 4.56 2.10 2.60
8 0.43 Aug-69 Aug-70 25.51 11.92 17.28 8.91 18.19 7.67 4.51 4.83 0.03 6.16 0.60 2.85
9 0.07 Jul-81 Jul-82 59.40 27.12 28.85 21.20 20.14 18.09 2.43 3.35 3.01 3.99 1.00 2.92
10 0.02 Dec-85 Dec-86 5.23 17.36 -0.27 8.67 -2.72 8.01 4.34 4.40 7.23 3.34 3.10 2.66
Prob Weighted Average 25.58 18.05 5.49 3.68 4.97 3.15 0.80 2.23 6.96 5.19 0.52 1.89
Average 27.59 17.32 9.08 6.71 8.58 6.23 2.01 3.34 2.40 3.97 0.30 2.22
Median 30.65 15.55 5.10 6.80 7.58 5.84 2.33 3.03 3.28 4.27 0.80 2.40
Max 59.40 29.64 28.85 21.20 22.79 18.09 4.51 8.62 17.60 8.12 3.10 3.37
Min -23.02 3.24 -2.22 -0.44 -6.11 -0.04 -0.75 0.84 -30.76 -5.68 -7.50 0.50
Prob Weighted Stdev 26.72 10.31 5.54 3.99 6.87 3.68 1.32 1.59 9.56 3.21 2.23 1.04
Stdev 24.11 8.68 9.79 6.41 10.07 5.61 1.77 2.27 12.79 3.94 3.08 0.91
Grand Average 12.06 10.69 6.08 5.93 5.86 5.55 3.94 3.96 3.98 3.47 2.20 2.04
Grand Min -67.57 -42.35 -18.17 -6.90 -17.10 -6.03 -2.91 0.12 -33.66 -9.70 -7.60 -2.54
Grand Max 162.88 43.34 46.74 23.85 54.41 25.42 17.96 11.25 31.67 22.39 16.30 10.39
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
13 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
Source: Quantitative Investment Group. For illustrative purposes only.
In a comparison to Figure 1 and 2, Figure 3 above shows that recession probabilities now
match the starting points of NBER recessions more accurately. However, especially after
the 1990s, we observe that the probabilities do not decrease as quickly after recessions.
This is because the recovery in nonfarm payroll data is slower than in earlier recessions
(see Figure 4). This suggests that inclusion of second-order lags may be useful in capturing
information about growth/decline periods as well as the value levels within a series.
fI gure 3: recessI on probabI LI tI es WI th I dentI fI ers cpI , I ndustrI aL
productI on, s&p 500 and nonfarm payroLLs
0.0
0.2
0.4
0.6
0.8
1.0
Aug-09 Jun-05 Jun-01 Jun-97 Jun-93 Jun-89 Jun-85 Jun-81 Jun-77 Jun-73
Recession Probability
NBER Recession Periods
Dec 2007 Peak
Nov 2001 Trough
Mar 2001 Peak
Mar 1991 Trough
Jul 1990 Peak
Nov 1982 Trough
Jul 1981 Peak
Jul 1980 Trough
Jan 1980 Peak
S&P 500 Year 25.00
CPI Y-o-Y Ch 25.00
INDPRO Y-o-Y 25.00
NONFARM 25.00
Identifier Weight (%)
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
14 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
Source: U.S. Department of Labor: Bureau of Statistics. For illustrative purposes only.
concLusI on
Low frequency macroeconomic forecasting that includes dating business cycles and
identifying regime changes has received increasing attention from investors and
policymakers. As a result, today, we have at our disposal a variety of approaches that seek
to address the regime identification issue as well as its impact on asset allocation.
To tackle this problem, traditional analyses in the literature have employed complex
econometric tools in which unobserved state variables augment autoregressive processes
to better approximate the nonlinearities in the data. Given their black-box nature
and the difficulty of replication due to subjective prior distributions and lack of global
optimization routines for parameter estimations, these models have been limited to
academic use.
On the other hand, as noted above, the mainstream industry approach to the regime
problem has been structural. Investment advisers tended to rely on charts and visual
inspection to extract patterns from historical episodes. The lack of scientific evidence
and a track record to support regime-related propositions has been a major disadvantage,
although the analyses and accompanying explanations have often seemed quite
convincing.
In this paper, our aim was to offer an alternative quantitative procedure which is practical
and which can be tailored for a variety of purposes in macroeconomic analysis. To this
end, we employed a kernel method called locally weighted scatter plot smoothing. This
method allowed us to rank historical periods that statistically resemble a current period
according to their similarity measured by a weighted distance. These similar periods in
history then can constitute the support for future extrapolations.
We demonstrated the procedure in a number of cases. First, inflation and growth were
used as regime identifiers. Second, we added asset returns to extract the message in
information-discounted market prices. Finally, we included a lagging indicator watched
by NBER to measure the performance in a turning-point dating process.
fI gure 4: totaL nonfarm payroLLs
-10
-5
0
5
10
15
20
2010 2000 1990 1980 1970 1960 1950 1930 1940
P
e
r
c
e
n
t

C
h
a
n
g
e

f
r
o
m

a

Y
e
a
r

A
g
o
Change in Non-Farm Payrolls NBER Recession Periods
Identifying regime changes
has received increasing
attention from investors and
policymakers. As a result,
we have at our disposal a
variety of approaches that
seek to address the regime
identification issue as well as
its impact on asset allocation.
Given their black-box
nature and the difficulty of
replication due to subjective
prior distributions and lack of
global optimization routines for
parameter estimations, these
models have been limited to
academic use.
In this paper, our aim was to
offer an alternative quantitative
procedure which is practical
and which can be tailored
for a variety of purposes in
macroeconomic analysis. To
this end, we employed a kernel
method called locally weighted
scatter plot smoothing.
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
15 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
Further research can be focused in a number of directions. For example, one might
employ additional time-dependent weights in local regressions to introduce dynamic
adaptation. In our context, this could make the 1930s era less similar to the current period
as policymakers have more tools to fight recessions. Another approach, for business
cycle dating purposes, would be to generate a routine for the supervised training of the
model i.e., the weights in the distance measure could be optimized to match NBER
turning points.
acknoWLedgment
We would like to thank the Teacher Retirement System of Texas Strategic Partnership
Network for initiating this research project. We are grateful for helpful comments
from John Mulvey and the members of the Quantitative Investment Group at
Neuberger Berman. This article reflects the views of the authors and does not reflect the
official views of the authors employer, Neuberger Berman.
references :
Ang, Andrew, and Geert Bekaert, How Regimes Affect Asset Allocation, Financial
Analyst Journal, Vol. 60, No. 2, Mar./Apr. 2004: 86 99.
Chauvet, Marcelle, and Jeremy Piger, A Comparison of the Real-Time Performance of
Business Cycle Dating Methods, Journal of Business and Economic Statistics, 26, 2008:
42 49.
Cleveland, William S., and Susan J. Devlin, Locally Weighted Regression: An Approach
to Regression Analysis by Local Fitting, Journal of the American Statistical Association,
Vol. 83, No. 403, Sep. 1988: 596 610.
http://www.jstor.org/stable/2289282
Cleveland, W. S., Robust locally weighted regression and smoothing scatter plots,
J. Amer. Statist. Assoc. 74(368): 829 836.
Guidolin, Massimo, and Allan G. Timmermann, Asset Allocation Under Multivariate
Regime Switching, Journal of Economic Dynamics and Control, Vol. 31, No. 11, 2007:
3503 3544.
Hamilton, James D., A New Approach to the Economic Analysis of Nonstationary Time
Series and the Business Cycle, Econometrica, Vol. 57, No. 2, March 1989: 351 384
Hrdle, Wolfgang, Applied Nonparametric Regression (Econometric Society Monographs),
1992, Cambridge University Press.
Ingersoll, Jonathan E., Theory of Financial Decision Making, Rowman & Littlefield,
Maryland, 1987.
Krugman, Paul, The Return of Depression Economics and the Crisis of 2008, W. W. Norton,
2008.
Merton, Robert C., Continuous-Time Finance, Blackwell Publishers, Cambridge, MA,
1994.
Strongin, Steve, Melanie Petsch, and Colin Fenton, Global Equity Portfolios and the
Business Cycle, Global Portfolio Analysis, Goldman Sachs working paper, April 7, 1997.
Tu, Jun, Is Regime Switching in Stock Returns Important in Asset Allocations?
EFA 2008 Athens Meetings Paper, June 2008. Available at SSRN: http://ssrn.com/
abstract=1028445.
regImes: nonparametrIc IdentIfIcatIon and forecastIng (continued)
16 Note: Opinions expressed herein are subject to change without notice. Past performance is not indicative of future results.
CONTACT INFORMATION
Hakan Kaya, Ph.D.
212.476.5667
hakan.kaya@nb.com
Wai Lee, Ph.D.
212.476.5668
wai.lee@nb.com
Bobby Pornrojnangkool, Ph.D.
212.426.5673
bobby.pornrojnangkool@nb.com
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