Economic Implications of Bull and Bear Regimes in UK Stock Returns∗

This paper presents evidence of persistent ‘bull’ and ‘bear’ regimes in UK stock returns and considers their economic implications from the perspective of an investor’s portfolio decisions. We Þnd that the perceived state probability has a large effect on the optimal allocation to stocks, particularly at short investment horizons. If ignored, the presence of such regimes gives rise to welfare costs that are substantial, particularly in the bear state where stock holdings should be signiÞcantly reduced. When we extend the return forecasting model to allow for predictability from the lagged dividend yield, we Þnd that both dividend yields and regime switching have strong effects on the optimal asset allocation.