Initial thoughts on the
impact of interest rates on six stock ETFs
In a previous post published in my finance blog I strongly
suggested that six extremely popular Stock ETS are overpriced at the end of
September 2016.
The previous post presented a bleak general assessment of
the investment environment. By
contrast, this post asks a very specific question.
What is the potential impact of an increase in interest
rates on the six popular broadbased stock ETFs presented in the previous post?
Assignment: Collect daily close stock market data for
six stock ETFs – VTI (total Stock market), VB (Small Cap Stocks), VV (Large Cap
Stocks), VUG (growth stocks), VDC (consumer stocks) and VIG (Dividend Stocks) –
over the period starting the first market day in 2014 to September 30,
2016. Use the data to estimate a distributed
lag model of the log of the daily stock price change on the 10year riskfree
interest rate.
Comment on the estimated impact of an increase in interest
rates on the price of these six conservative stock ETFs.
Discuss the limitations of these distributed lag results.
Suggest refinements to this empirical work that would lead
to a better understanding of the impact of interest rate changes on ETF prices.
A Note on data and
the Model: The data used in this
paper was downloaded from yahoo finance.
The model was estimated with 545 closing price and closing 10year ETF
interest rate observations starting from the beginning of 2014 to September 30
2016.
The dependent variable in this analysis is the log of the
price of the ETF. The independent variables
are the lag of the dependent variable and the log of the 10year Treasury
interest rate.
Results: The table below contains the estimated
regression coefficients and the pvalue for the test that the coefficient is
zero for the lagged dependent variable and the 10year interest rate variable.
Results of Distributed
Lag Model of Stock Price on TenYear Interest Rate


Fund

VTI

VB

VV

VUG

VDC

VIG

Fund Description

Total Stock Market

Small Cap Stocks

Large Cap Stocks

Growth Socks

Consumer Stocks

Dividend Stocks

Lag Dependent Variable
Coeff

0.969

0.972

0.969

0.972

0.972

0.96

pvalue

0

0

0

0

0

0

Ten Year Interest rate
Coeff.

0.0074

0.0045

0.0077

0.0077

0.015

0.0065

pvalue

0.01

0.08

0.01

0.02

0

0.01

Sample size

545

545

545

545

545

545

R2

97.8

96.8

98

98.1

99.4

96.6

MSE

0.00867

0.00966

0.00859

0.00924

0.0075

0.0078

Discussion of
Results:
The estimated coefficient of the interest rate variable is
negative for all 6 stock ETF models.
The pvalue is near 0.01 for 5 of the six coefficients. The relationship between interest rates and
stock prices appears significant at conventional levels of significance.
Interest rates appear to have the largest impact on consumer
stocks and the smallest impact on smallcap stocks.
The lagged dependent variable is very close to 1.0
suggesting that the longterm effect of a change in interest rates is larger than
the shortterm effect. (However, please
see the comment below on this point.)
Comments and Caveats:
The longterm effect of the change of interest rates on the
log of the stock price is interest rate coefff/ ( 1 lagged dependent variable
coefficient). I did not correct for
firstorder serial correlation in these regression models. This ordinary least squares estimation
method may have resulted in a biased estimate of the lagged dependent variable
coefficient if the firstorder AR term is correlated with the lagged dependent
variable. Future work will correct for
this problem.
I believe that the relationship between interest rates and
stock prices varies with economic conditions.
Right now economic growth remains slow but the economy is near full
employment defined by the traditional unemployment rate and interest rates
remain near historic lows. Stock prices
are high and some would say the stock market is in a bubble. Under these circumstances I am not surprised
that the relationship between interest rates and stock prices is negative.
Under different economic circumstances the relationship
between interest rates and stock prices might be positive. For example, the drop in interest rates
during the 2008 financial crisis coincided with a drop in stock prices because
both events were caused by the decrease in aggregate demand.
Concluding Thoughts: The impact of interest rates on stock prices
is a timely issue given that interest rates are near their historic lows, stock
prices are very high and interest rate policy at the Fed and the market
reaction to factors impacting interest rates may soon change.
This essay is my first attempt to model the impact of
interest rates on stock prices. The results presented here suggest that the
major stock ETFs will fall in value should interest rates begin to rise. These results reinforce my pessimistic view
of the investment environment discussed in the finance post cited at the
beginning of this article.
The model used here is admittedly simple. The model would not consistently predict
stock price changes over a long period where many economic variables
changed. However, parsimonious models
of this type are often effective when used to assess shortterm changes.
Future work will consider more complex models and measures
of interest exposure starting with the comments and caveats listed above.
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