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Multi-Asset Market Regimes

November 9, 2012

An astute reader suggested reproducing the results from a recent article on regime analysis by Kritzman et al., Regime Shifts: Implications for Dynamic Strategies in FAJ (May / June 2012). This is a fun exercise to be conducted over a series of posts, as doing so illustrates several important economic principles and some elegant mathematics.

This post begins by identifying macroeconomic market regimes arising from multi-asset economic activity.

One big challenge in analyzing market regimes is identification, as they are not directly observable. As an unsupervised statistical learning problem, there is no verifiable “right answer”. Beyond identifying regimes, we also want to know the probability of being in a given regime at any given point in time. Finally, our economic activity is measured via time series.

Fortunately, a standard ML technique exists which possesses these attributes: hidden Markov model (HMM). For readers unfamiliar with HMM, here is a brief summary on the theory relevant to our problem. See Hidden Markov Models for Time Series by Zucchini and MacDonald (2009) for more details.

HMMs are useful because they estimate both unobserved regimes and corresponding probabilities of being in each regime at every point in time. The latter is termed “local decoding”, and expressed as the conditional state probabilities:

   \text{Pr}(C_t = i | \bf{X}_T = \bf{x}_T) = \frac{\text{Pr}(C_t = i, \bf{X}^T = \bf{x}^T)}{\text{Pr}(\bf{X}^T = \bf{x}^T)}

In other words, the probability of being in regime i at time t given the observed data \bf{x}_T.

Where \bf{X} is the observed time-series data and C is an unobserved parameter process which conditional probability at time t depends at most on the previous time (t-1), also known as the Markov property:

   \text{Pr}(C_{t+1} | C_t, ..., C_1) = \text{Pr}(C_{t+1} | c_t)

Thus, C is an unobservable Markov chain; because of which the conditional probability at time t nicely reduces to (see equation 5.6 in Zucchini, derived from 4.9):

   \text{Pr}(C_{t+1} | C_t, ..., C_1) = \frac{\alpha_t(i) \beta_t(i)}{L_T}

Where \alpha_t(i) and \beta_t(i) are forward and backward probabilities along the Markov chain C at time t (estimated via iterative maximum likelihood using expectation maximization), and L_T is the likelihood at time T .

For those who prefer code, where val is observed time series \bf{X} and numOfStates is number of unobserved regimes for C:

hmmFit <- HMMFit(val, nStates=numOfStates)
fb <- forwardBackward(hmmFit, val)
eu <- exp(fb$Alpha + fb$Beta - fb$LL)

Readers with ML background will recognize HMM as an elementary temporal graphical model (see § 6.2 of Koller and Friedman (2009)).

With this tiny bit of HMM theory, we can now formulate our regime analysis problem in economic terms and use a bit of R to solve it.

Consider four measures of economic activity: US equities, real gross domestic product (GDP), inflation, and G10 currencies. Posit each measure of economic activity can be characterized at any point in time as being in either one of two states: stable with corresponding small downside volatility or contracting with corresponding high volatility. This broadly matches traditional wisdom, namely the macroeconomy is either acting “fairly normal” or is exceptional (either panic or exuberance).

Worth noting is the obvious caveat that this bi-state model oversimplifies reality, in particular ignoring potential distinction between “growth” and “stagnancy” (of potential importance during 1970s and 2010s). Intuition is unclear a priori whether a bi- or tri-state model is preferable. A subsequent post will take up this model selection question, as it lacks an easy answer.

Illustrating the conditional probabilities of this model graphically, where a value of 0 indicates 100% likelihood of being in the “normal” regime and value of 1 indicates 100% likelihood of being in “exceptional” regime:

These regimes match our economic recollection. Equities were normal through much of the 1990s and mid-2000, and in panic the remaining time. GDP growth was exceptionally strong in the mid-1990s, during recovery from dotcom bubble in early 2000s, and during recovery of mortgage bubble in late 2000s; growth during all other times was “normal”. Inflation was high during the late 1970s and flanking the mortgage bubble. Currencies were volatile throughout 1980s and 1990s and then again flanking the mortgage bubble.

These regimes also illustrate just how unusual the mortgage bubble was in historical sense, as it is the only time in the past 30 years during which all four measures of macroeconomic activity were simultaneously in exceptional regime.

Code to replicate the above results, and quite a bit more to be discussed in subsequent posts.

Note: US equity regime is estimated using daily returns from SPX, rather than equally-weighted basket of S&P 500 sector indices as in the original article. Doing so results in nearly identical equity regime conditional probabilities, hence SPX is chosen in recognition of Occam.


displayKritzmanRegimes <- function()
  # Display regimes from Kritzman et al. (2012), printing regime
  # statistics and plotting local decoding.
  equityRegime <- getEquityTurbulenceRegime()
  inflationRegime <- getInflationRegime()
  growthRegime <- getGrowthRegime()
  currencyTurbulenceRegime <- getCurrencyTurbulenceRegime()

  plotMarkovRegimes(equityRegime, "Equity (SPX)", plotDensity=F)
  plotMarkovRegimes(inflationRegime, "Inflation (CPIAUCNS)", plotDensity=F)
  plotMarkovRegimes(growthRegime, "Real GDP (GDPC1)", plotDensity=F)
  plotMarkovRegimes(currencyTurbulenceRegime, "G10 Currency Turbulence", 
  plotLocalDecodings(list(equityRegimeTurbulence, growthRegime, inflationRegime, 
                     list("US Equity (SPX)", "Real GDP (GDPC1)", 
                          "Inflation (CPIAUCNS)","G10 Currency Turbulence"),

getEquityTurbulenceRegime <- function(startDate=as.Date("1977-12-01"), 
                                      endDate=Sys.Date(), numOfStates=2)
  # Estimate two-state markov (SPX-based) equity regime. In lieu of S&P 500
  # sector indices, use SPX instead.
  # Args:
  #     startDate: date which to begin panel for regime estimation
  #     endDate: end which to end panel for regime estimation
  #     numOfStates: number of hidden states in regime
  # Returns: hmmFit from HMMFit(), suitable for display with plotMarkovRegime()
  spx <- dROC(getOhlcv(instrumentSymbol="^GSPC", startDate=startDate, 
                              endDate=endDate, quote=c("close")))
  spxTurb <- rollingTurbulence(spx, avgWidth=(250 * 10), 
                                    covarWidth=(250 * 10))
  meanTurb <- apply.monthly(spxTurb, mean)
  estimateMarkovRegimes(meanTurb, numOfStates=numOfStates)

getInflationRegime <- function(startDate=as.Date("1946-01-01"), endDate=Sys.Date(),
  # Estimate two-state markov (CPI-based) inflation regime.
  # Args:
  #     startDate: date which to begin panel for regime estimation
  #     endDate: end which to end panel for regime estimation
  #     numOfStates: number of hidden states in regime
  # Returns: hmmFit from HMMFit(), suitable for display with plotMarkovRegime()
  val <- 100 *dROC(getFREDData(symbol="CPIAUCNS", startDate=startDate, 
  estimateMarkovRegimes(val, numOfStates=numOfStates)

getGrowthRegime <- function(startDate=as.Date("1946-01-01"), 
                            endDate=as.Date("2012-12-31"), numOfStates=2)
  # Estimate two-state markov (GDP-based) growth regime.
  # Note: Growth regime appears to be bi-modal, and thus need to estimate
  # several times to get convergence on the regime reported by Kritzman.
  # Args:
  #     startDate: date which to begin panel for regime estimation
  #     endDate: end which to end panel for regime estimation
  #     numOfStates: number of hidden states in regime
  # Returns: hmmFit from HMMFit(), suitable for display with plotMarkovRegime()
  val <- 100 * dROC(getFREDData(symbol="GDPC1", startDate=startDate, 
  estimateMarkovRegimes(val, numOfStates=numOfStates)

getCurrencyTurbulenceRegime <- function(startDate=as.Date("1971-01-01"), 
  # Estimate two-state markov (G10-based) currency turbulence regime.
  # Args:
  #     startDate: date which to begin panel for regime estimation
  #     endDate: end which to end panel for regime estimation
  #     numOfStates: number of hidden states in regime
  # Returns: hmmFit from HMMFit(), suitable for display with plotMarkovRegime()
  g10rates <- getG10Currencies()
  avgg10rates <- xts(100 * rowMeans(dROC(g10rates), na.rm=T), 
           , -1))
  turbG10rates <- rollingTurbulence(avgg10rates, avgWidth=(250 * 3), 
                                    covarWidth=(250 * 3))
  meanTurbG10rates <- apply.monthly(turbG10rates, mean)
  estimateMarkovRegimes(meanTurbG10rates, numOfStates=numOfStates)

estimateMarkovRegimes <- function(val, numOfStates=2)
  # Estimate n-state hidden markov model (HMM) for val.
  # Args:
  #     val: series
  #     numOfStates: number of hidden states in HMM
  # Returns: hmmFit from HMMFit(), suitable for display with plotMarkovRegime()
  hmmFit <- HMMFit(val, nStates=numOfStates)
  return (list(val=val, hmmFit=hmmFit))

plotLocalDecodings <- function(regimes, symbols, plotDateRange="1900::2012", 
  # Plot local decodings for a list of HMM regimes, optionally over a set
  # date range.
  # Args:
  #     regimes: list of regimes, as returned by estimateMarkovRegimes()
  #     symbols: list of human-readable symbols for regimes
  #     plotDateRange: option date over which to plot regime local decodings
  #     regimeNums: index of HMM regime, into regimes, to plot
  oldpar <- par(mfrow=c(1,1))
  # generate merge of local decodings
  localList <- lapply(c(1:length(regimes)), function(i) {
    regime <- regimes[[i]]
    fb <- forwardBackward(regime$hmmFit, regime$val)
    eu <- exp(fb$Alpha + fb$Beta - fb$LL)
    local <- xts(eu[,regimeNums[i]], index(regime$val))[plotDateRange]
    plota(local, type='l', plotX=T, col=drawColors[i], main=symbols[i])

plotMarkovRegimes <- function(regime, symbol, plotDateRange="1900::2012",
                              plotDensity=T, plotTimeSeries=T)
  # Plot markov regimes from HMM: kernel densities and per-regime local decodings.
  # Args:
  #     hmmFit: fit for HMM, as generated by estimateMarkovRegimes()
  #     symbol: human-readable description of series with markov regimes
  #     plotDateRange: contiguous range of time which to plot
  val <- regime$val
  hmmFit <- regime$hmmFit
  # calculate local decoding
  fb <- forwardBackward(hmmFit, val)
  eu <- exp(fb$Alpha + fb$Beta - fb$LL)
  hmmMeans <- hmmFit$HMM$distribution$mean
  hmmSD <- sqrt(hmmFit$HMM$distribution$var)
  # plot kernel density with regime means
  oldpar <- par(mfrow=c(1,1))
  if (plotDensity)
    plot(density(val), main=paste("Density with Regime Means:", symbol))
    abline(v=mean(val), lty=2)
    sapply(c(1:length(hmmMeans)), function(i) {
      abline(v=hmmMeans[i], lty=2, col=drawColors[(i+1)])
      curve(dnorm(x, hmmMeans[i], hmmSD[i]), add=T, lty=3,

  # Plot time series of percent change and local decoding for each regime
  if (plotTimeSeries)
    merged <- merge(val, eu)
    plota(merged[,1][plotDateRange], type='l', paste("Regime:", symbol), plotX=F)
    sapply(c(1:length(hmmMeans)), function(i) {
      abline(h=hmmMeans[i], lty=2, col=drawColors[(i+1)])
    plota.legend("Percent Change:", drawColors[1], last(merged[,1]))
    sapply(c(1:ncol(eu)), function(i) {
      plota(xts(merged[,(i+1)], index(val))[plotDateRange], type='l', 
      plota.legend(paste0("Event Regime ", i, ":"), drawColors[(i+1)], 

dROC <- function(x, n=1)
  # Return discrete rate-of-change (ROC) for a series, without padding
  ROC(x, n, type="discrete", na.pad=F)
20 Comments leave one →
  1. Sam permalink
    November 9, 2012 6:58 pm

    Nice post, which package does the dROC, getOhlcv etc functions reside in?

    • quantivity permalink*
      November 9, 2012 8:29 pm

      @Sam: thanks for complement.

      Re functions: some are common utility functions, which are not currently packaged; others are private because they depend on access to a large private data warehouse, which cannot be replicated with standard quantfin libraries (e.g. quantmod, etc).

      If there is sufficient reader interest, I can make the utility functions available.

      • Eduardo permalink
        November 9, 2012 11:53 pm

        I am looking at the code and I guess dROC is the same as TTR::ROC using type=”discrete”? Then, I guess getOhlcv is the same as quantmod:getSymbols just that it looks in your DWH? If this is true, then the only function missing definition and source code is rollingTurbulence since I can not find it anywhere else in R universe. I would appreciate if you can share the code.

        Otherwise, I guess the simplest thing would be to use data from FRED downloading it using getSymbols and using src=”FRED” and the example would be reproducible completely…

        Any chance to share code asked for in the comment section of another great article from you ? Thank you.

      • quantivity permalink*
        November 10, 2012 8:58 am

        @Eduardo: I added dROC to the post. I have a version of the data access functions functions which stub into quantmod equivalents (and vice versa, so these functions interoperate with OHLCV functions), which I can make available in a subsequent post depending on reader interest.

        Covering turbulence is on the agenda for subsequent post in this series, as this paper depends on it (not to mention Kritzman is an author on a preceding paper covering turbulence).

        Finally, I can share TAQ code in a post subsequent to this market regime series.

  2. November 12, 2012 9:41 pm

    Thanks for the hmmFit package pointer.

  3. Niclas permalink
    November 16, 2012 11:04 pm

    Thank you for a great post. You mention you have a large private data warehouse. Which sources do you use? Any suggestions on how to store such quantity of data (H2, sql, csv, …). Any special R packages you recomend?

    Thanks, looking forward to your next post.

  4. December 25, 2012 9:35 pm

    Thanks for this post and the accompanying code.
    The rollingTurbulence function does not seem to be part of the code. Is it part of your private data/code warehouse?
    Please share it if possible.


  5. Alain permalink
    February 11, 2013 2:24 am

    “Intuition is unclear a priori whether a bi- or tri-state model is preferable. A subsequent post will take up this model selection question, as it lacks an easy answer.”

    You should look at a paper of otranto and gallo who proposes a nonparametric bayesian aproach to estimate the number of regimes

    hope that’s a useful comment.


    • quantivity permalink*
      February 11, 2013 10:33 pm

      @Alain: thanks for your comment, I will take a look at the paper.

  6. Arthur permalink
    March 6, 2013 7:23 am

    I was researching exactly this topic after I’ve seen a demonstration of it at a quant conference earlier this year. I found the following tutorial very helpful:

    The presenter showed two models for timing risk-on/off – an HMM and a simple moving average model (MA50 > MA200 = risk-on and vice-versa). The HMM was much more elegant of course, but performance-wise there wasn’t much of a difference…

    • quantivity permalink*
      March 6, 2013 8:42 am

      @Arthur: thanks for link to Rabiner; although dated, I concur it is one of the best introductory tutorials.

      Re risk on/off: I concur MA models are competitive with HMM for US equity indices, although average lengths are somewhat regime-sensitive (e.g. 50/200 has not worked consistently over the past 20 years). For other instruments and markets (especially spreads and synthetics), HMM models may be superior.

  7. Jonathan permalink
    August 22, 2013 2:52 pm

    I just stumbled across your blog today and am enjoying your impressive posts. I see you are active on Twitter but haven’t posted here for a while. I am interested if you have plans to post the rollingTurbulence implementation so that I can look at your regime results over more current time periods.


    • quantivity permalink*
      August 22, 2013 8:30 pm

      @Jonathan: thanks for your kind words. Yes, I will do a follow-up post on turbulence, given the interest in seeing full implementation.

  8. November 30, 2013 11:20 am

    any chance to see a follow-up for this beautiful article?

  9. March 22, 2014 8:59 am

    Reblogged this on Edgar's Real Edge and commented:
    Recently discovered Blog on Quantitative Trading. Ina single word: excellent!

  10. VanDer permalink
    October 26, 2015 8:46 am

    Good post.
    A question on the equity turbulence – did you use the S&P 500 constituents in calculation of the turbulence? Because the turbulence index requires cross-mean and covariance matrix.

  11. akshay sharma permalink
    December 27, 2016 2:32 am

    Hi I am new to R can Please anyone help in in running this code, as i dont get an output when i paste this code in my R console

  12. Sheron Perchinski permalink
    March 31, 2018 9:45 am

    This website is completely gret. I’ve ask these informations a long time and I realised that
    is professional, easy to understand. I congratulate
    you for this research that I’ll recommend to prospects
    around. I ask you to visit the site where each
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  1. Asset Pricing [9a : Regime Switching] | Alpha Hive ::

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