Crude, Gold, Treasury Yields and VIX – Which one is most Predictive of Dow Jones Industrial Average?

-- Intended for New College Graduates --

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Julie is interviewing for an Equity Analyst position with a Wall Street Brokerage firm.

Question # 1
Interviewer: Julie, we used 13-months (i.e., 07/01/2018 thru 07/31/2019) worth of daily closing prices to compile this correlation matrix and the regression graph. Now, by looking at them, can you tell me what our objective here is?

Julie: You are trying to see if Gold, 10 and 30-year Treasury Yields, Crude and VIX collectively can predict Dow Jones Industrial Average (DJIA).

Question # 2
Interviewer: Why did we use ETFs like GLD and XOP instead of the actual futures data?

Julie: Futures contracts have different expiration dates so combining such data from different contract periods would be discontinuous. ETFs, instead, would be much better proxies.

Question # 3
Interviewer: In this example, is VIX the most un-correlated with DJIA? Qualify your answer with the underlying theory.

Julie: No. It's the most correlated of the five independent variables. Correlation can be positive or negative, hence the correlation coefficient varies between +1 and -1. VIX is negatively correlated with DJIA here.

Question # 4
Interviewer: In that case, which one is the least correlated independent variable here?

Julie: It's the crude ETF, that is the XOP variable in the equation.

Question # 5
Interviewer: Based on this correlation matrix, would you use all of the five independent variables in the regression equation? Qualify your answer with the underlying theory.    

Julie: No. I would remove GLD and 30-year Treasury Yield right off the top because they are failing the test of multi-collinearity. GLD is highly correlated with three others, while the 30-year Yield is moving in lockstep with the 10-year Yield.

Question # 6
Interviewer: Why did you choose 10-year Yield over 30-year Yield? Aren't they interchangeable here?

Julie: 10-year has better predictive relationship with the DJIA and lesser correlation with the VIX, while 30-year has only one positive, that is lesser correlation with XOP. Out of three, two positives here are better than one positive. Therefore, they are not necessarily interchangeable here.

Question # 7
Interviewer: The regression line shows a r-squared of 0.7633. What r-squared would the actual regression output show?

Julie: The same 0.7633. The regression value here represents all five independent variables against the same DJIA dependent variable so the r-squared would be identical. You are basically graphing the outcome of the actual regression.

Question # 8
Interviewer: If you are asked to fine-tune the model with an improved r-squared, what would you do? Qualify your answer with the underlying theory.

Julie: I would remove some outliers systematically from both ends of the curve. Unlike weekly closing prices, daily closing prices are inherently very volatile, so removing some outliers would be reasonable.

Question # 9
Interviewer: If you are forced to run a simple regression, rather than a multiple regression comprising these five variables, which one would you choose? And, what type of regression coefficient would you expect to see?

Julie: VIX, because it has the best predictive relationship with the DJIA. The regression coefficient would be negative as well, in line with the correlation coefficient.

Disclaimer - The author is not advocating the ETFs/indices listed here. Consult your Registered Rep, RIA or Financial Planner for an appropriate asset allocation model and the suitability of stocks, indices and other holdings for your portfolio.

Good Luck!

Sid Som, MBA, MIM
President, Homequant, Inc.
homequant@gmail.com

Coming soon: Sid's New Book: Modern Interviewing Techniques and Skills - Live Simulations with Actual Market Data