The Hidden Markov model (HMM) is typically used to predict the hidden regimes of observation data. The idea here is looking for major changes in trend by analysing prices, which are observable. The “hidden” aspect is the market’s current state. Bear and bull markets aren’t directly observable and so these regimes can only be inferred via price trends in a probabilistic framework.
It is an econometric test for bull-bear market signals. Identifying the start of bear and bull market in real time is quite difficult but this statistical technique known as HMM solves this problem. It recognize as early as possible with a high level of confidence that the market’s transitioned from bull to bear and vice-versa.
The model determines the most probable state sequence (market regime) and computes the probability of the state sequence (Bear and Bull market probability).
S&P 500 Market Index, Sample Period : 2-Jan-1981 to 09-Sep-2016
According to the HMM model, the US market entered into a “bull” regime and the bear market probability fell to 10% as of 09-Sep-2016. S&P 500 hovered around 2127 on 09-Sep-2016 and it reached the level of 2259 as of 09-Dec-2016. The gain of 6% in such a short span of time if one has made an investment as per HMM.
The model is built into R (Statistical Software) and is a very useful tool to assess bull and bear market signal. The model is tested again on 09-Dec-2016 and it reflects the bull market still persists. So continue to keep investing and make money.