A Forecasting Model for Stock Market Diversity

We apply the recently introduced generalized tree-structured (GTS) model to the analysis and forecast of stock market diversity. Diversity is a measure of capital concentration across a market that plays a central role in the search for arbitrage. The GTS model allows for different conditional mean and volatility regimes that are directly related to the behavior of macroeconomic fundamentals through a binary threshold construction. Testing on US market data, we collect empirical evidence of the model's strong potential in estimating and forecasting diversity accurately in comparison with other standard approaches. In addition, the GTS model allows for the construction of very simple portfolio strategies that systematically beat the standard cap-weighted S&P500 index.