This study proposes a regime-based asset allocation strategy to improve Hong Kong equity portfolio returns. Investors are well aware that the stock market switches between bullish periods of substantial increase in market prices and bearish periods of persistent decrease in market prices. As these two different market regimes have a significant impact on the return of equity portfolios, it is worthwhile for investors to forecast the regime-switching behaviour of the market.
I apply the Markov-regime switching approach to model the shifts in Hong Kong stock market returns between bull and bear market regimes. This Hong Kong stock market regime-switching model is able to identify and forecast the regimes in market returns. A practical investment framework based on the forecast turning points in market regimes is developed in the research. Asset allocation decisions will be driven by shifts in market regime. This regime-based asset allocation strategy is tested with out-of-sample data and it is concluded that the strategy outperforms the buy-and-hold investment strategy.