Stock return predictability and model instability: Evidence from mainland China and Hong Kong

Results indicate higher linear stock return predictability for the Hong Kong market than for the Chinese markets. However, the results differ when model instability is considered. Specifically, using Bai and Perron's (1998, 2003) approach, the results indicate the presence of structural breaks particularly for the Shenzhen market, which appear to coincide with major economic events or political and institutional changes. The predictable component in stock returns is also time-varying when re-estimating the model over different subsamples defined by the break. Overall, results highlight the importance of considering breaks in forecasting stock returns, and suggest that the Hong Kong market is a relatively ideal haven to park wealth for risk-averse investors whereas the Shenzhen market offers enhanced opportunities for risk-seeking investors.