Decoding Chinese Stock Market Returns : Three-State Hidden Semi-Markov Model

In this paper, we employ a three-state hidden semi-Markov model (HSMM) to explain the time-varying distribution of the Chinese stock market returns since 2005. Our results indicate that the time-varying distribution depends on the hidden states, which are represented by three market conditions, namely the bear, sidewalk, and bull markets. We find that the inflation, the PMI, and the exchange rate are significantly related to the market conditions in China. A simple trading strategy based on expanding window decoding shows profitability with a Sharpe ratio of 1.14