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There is speculation that the Federal Reserve of the United States will raise interest rates by 0.25% in the near future. What is the expected effect on the stock market if interest rates do rise by that amount? More specifically, what is the predicted effect on the Dow Jones Industrial Average?

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Each component of the Dow Jones Industrial Average (DJIA) has a yield, computed as the earnings divided by the price, expressed as a percentage. For example, if a stock is priced at $100.00 and yearly earnings of $10.00 per share, then the yield for that stock is

yield = earnings / price = $10.00 / $100.00 = 10%

That yield could be paid out as a dividend, or retained and reinvested to grow the company, doesn't matter to this analysis.

The first step in the analysis is to determine the yield for each of the 30 components of the DJIA. On August 18, 2015 the DJIA closed at 17511.34, and the yields for the component companies were

    Company     Price Earnings  P/E  Yield
Visa            74.47   2.16   34.5  2.90%
Microsoft       47.27   1.46   32.4  3.09%
Nike           114.82   3.70   31.0  3.22%
Procter         75.13   2.44   30.8  3.25%
HomeDepot      122.80   4.71   26.1  3.84%
Coca-Cola       41.30   1.60   25.8  3.87%
WaltDisney     106.94   4.26   25.1  3.98%
Pfizer          35.52   1.42   25.0  4.00%
UnitedHealth   125.50   5.70   22.0  4.54%
McDonald's     100.76   4.82   20.9  4.78%
3M             148.31   7.49   19.8  5.05%
Verizon         47.46   2.42   19.6  5.10%
Boeing         144.60   7.38   19.6  5.10%
Johnson         99.37   5.70   17.4  5.74%
GE              26.07   1.50   17.4  5.75%
Cisco           28.25   1.73   16.3  6.12%
Merck           59.66   4.07   14.7  6.82%
AmExpress       81.24   5.56   14.6  6.84%
UnitedTech      99.41   6.82   14.6  6.86%
WalMart         69.48   5.05   13.8  7.27%
DuPont          53.90   3.92   13.8  7.27%
Apple          116.50   8.66   13.5  7.43%
Caterpillar     78.82   5.88   13.4  7.46%
IBM            156.01  11.90   13.1  7.63%
JPMorgan        68.21   5.29   12.9  7.76%
Intel           28.91   2.36   12.2  8.16%
Goldman        201.18  17.07   11.8  8.48%
Exxon           77.90   7.60   10.3  9.76%
Travelers      107.82  10.70   10.1  9.92%
Chevron         83.44  10.14    8.2 12.15%

The next step in the analysis is to determine the adjusted yield after the Federal Reserve increases the interest rates by 0.25%.

The expectation is that the market will adjust prices to increase yields by 0.25%. In other words, market yields represent a premium above the Federal Reserve rate.

So for example, the yield on Visa must increase from 2.90% to 3.15% to compensate for a 0.25% increase in the Federal Reserve rate. Given earnings of $2.16, the price must drop from $74.47 to $68.56 (a 7.9% drop) to compensate for the rate increase. At the other end of the scale, the yield on Chevron must increase from 12.15% to 12.40%. Given earnings of $10.14, the price must drop from $83.44 to $81.76 (a 2% drop).

We can now augment the previous table to include the adjusted yields, adjusted prices, and the drop in price as a percentage of the original price.

                                                  Adjusted    Price
    Company     Price Earnings  P/E  Yield     Yield   Price  Change
Visa            74.47   2.16   34.5  2.90%     3.15%   68.56  -7.94%
Microsoft       47.27   1.46   32.4  3.09%     3.34%   43.73  -7.49%
Nike           114.82   3.70   31.0  3.22%     3.47%  106.55  -7.20%
Procter         75.13   2.44   30.8  3.25%     3.50%   69.76  -7.15%
HomeDepot      122.80   4.71   26.1  3.84%     4.09%  115.29  -6.12%
Coca-Cola       41.30   1.60   25.8  3.87%     4.12%   38.80  -6.06%
WaltDisney     106.94   4.26   25.1  3.98%     4.23%  100.62  -5.91%
Pfizer          35.52   1.42   25.0  4.00%     4.25%   33.43  -5.89%
UnitedHealth   125.50   5.70   22.0  4.54%     4.79%  118.95  -5.22%
McDonald's     100.76   4.82   20.9  4.78%     5.03%   95.76  -4.97%
3M             148.31   7.49   19.8  5.05%     5.30%  141.31  -4.72%
Verizon         47.46   2.42   19.6  5.10%     5.35%   45.24  -4.67%
Boeing         144.60   7.38   19.6  5.10%     5.35%  137.85  -4.67%
Johnson         99.37   5.70   17.4  5.74%     5.99%   95.22  -4.18%
GE              26.07   1.50   17.4  5.75%     6.00%   24.98  -4.16%
Cisco           28.25   1.73   16.3  6.12%     6.37%   27.14  -3.92%
Merck           59.66   4.07   14.7  6.82%     7.07%   57.55  -3.54%
AmExpress       81.24   5.56   14.6  6.84%     7.09%   78.38  -3.52%
UnitedTech      99.41   6.82   14.6  6.86%     7.11%   95.91  -3.52%
WalMart         69.48   5.05   13.8  7.27%     7.52%   67.17  -3.33%
DuPont          53.90   3.92   13.8  7.27%     7.52%   52.11  -3.32%
Apple          116.50   8.66   13.5  7.43%     7.68%  112.71  -3.25%
Caterpillar     78.82   5.88   13.4  7.46%     7.71%   76.26  -3.24%
IBM            156.01  11.90   13.1  7.63%     7.88%  151.06  -3.17%
JPMorgan        68.21   5.29   12.9  7.76%     8.01%   66.08  -3.12%
Intel           28.91   2.36   12.2  8.16%     8.41%   28.05  -2.97%
Goldman        201.18  17.07   11.8  8.48%     8.73%  195.42  -2.86%
Exxon           77.90   7.60   10.3  9.76%    10.01%   75.95  -2.50%
Travelers      107.82  10.70   10.1  9.92%    10.17%  105.17  -2.46%
Chevron         83.44  10.14    8.2 12.15%    12.40%   81.76  -2.02%

The adjusted DJIA computed from the adjusted prices is 16747.96. Thus, the DJIA was expected to drop from 17511.34 to 16747.96 (a 760 point 4.4% drop) to compensate for a 0.25% increase in the Federal Reserve rate.

What actually happened was the DJIA dropped to a low of 15666.44 low on August 25, 2015 (an 1840 point 10.5% drop) before recovering to a range between 16300 and 16500, slightly below the expectation.

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    $\begingroup$ This analysis rests on a number of very strong assumptions... for example, the assumption that markets are not forward-looking— that the prices on August 18, 2015 did not reflect the expectation that the Fed will raise rates by 0.25% (or when the market expects that increase to happen), or the assumption that price movements between August 18th and August 25th had everything to do with interest rates and nothing to do with any other factors... $\endgroup$ – dismalscience Sep 10 '15 at 21:53
  • $\begingroup$ @dismalscience You make two excellent points. I agree that it's difficult to separate the effects of interest rate hikes from other factors. The fact that the market dropped 1000 points more than expected and only recovered to about 350 below expectations indicates that other factors are in play. $\endgroup$ – user3386109 Sep 10 '15 at 22:07
  • $\begingroup$ Second, let's assume that the market is forward-looking and the DJIA at 17511 had pre-compensated for the 0.25% increase. The Fed has been talking about increasing rates for a long time now, but hasn't done it. Hence, when they finally do increase rates, a forward-looking market must begin pre-compensating for the next increase. I suggest therefore, that 08/19/2015 was the date that the market was finally convinced that the 0.25% increase was actually going to happen, and the market began pre-compensating for the next increase. $\endgroup$ – user3386109 Sep 10 '15 at 22:07
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From a less analytical standpoint:

user3386109's answer is a good one, and based on the assumptions he/she made, this would/should occur. In this case, a couple things could occur.

On the one hand, there may no change. That is, from a traditional economic analysis, we would expect the stock holder to have perfect information, be rational, and as a result there would not be any change in the buying and selling habits of brokers. That is, every agent would notice there was an equal drop across the board, and not that universally something has changed.

This may not be far from the truth, since more, if not all, trading is done via computer systems. However because of this, there may be incremental lag for those computers and programs which see the shift in yield, due to interest rates late. This is a result of connection times and frequency of trade issues.

A more practical approach:

It is hard to say exactly what will happen if there is an increase in interest rate. But, from a more practical standpoint, it is hard to assume that all agents are rational, and have perfect information, with no time-lag in trade deals or recognition.

For instance those businesses which do not deal in the loan market as frequently may do better than expected; they will not feel the pinch of the interest rate as greatly as a company which deals frequently in the loan market.

There, also, may be different effects for emerging companies that hope(d) to go public. Raising the interest rate effects the loan market in the simple sense that it makes paying back harder. If new business, which are growing because of such and such a reason find difficulty in the interest hike, there could be psychological factors which deter other investors, and the company itself.

But, for a majority of the business on the NASDAQ, or Dow, it would be shocking if they did not look forward. Many of these companies have divisions and persons dedicated to making sure that they stay current with future changes.

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when you say 'effect,' i'm not really sure whether you're looking for a rigorous econometric model or, as the guy ahead of me wrote, a more practical, investor-oriented approach.

most of the sectors you'd would expect to take a beating given a rise in debt costs - construction, commodities, energy - have been trading on the cheap for a while now. (fwiw...inexpensive and highly-cyclical sectors are always intriguing)

it will be interesting to see whether a rising rate environment a) spikes the housing market as buyers try and snap up loans while rates are still low or b) totally guts already tepid demand. but that presumes an environment where rates are rising consistently, as opposed to maybe just once this december, which may be presuming too much.

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