Gold, Currency Dilution - And Should The Market Go Higher?

May.14.13 | About: SPDR Gold (GLD)

There has been much renewed discussion lately about how the Federal Reserve's unwinding of QE3 will affect the market. In an article by Jon Hilsenrath in the Wall Street Journal that came out Friday afternoon he said that the Fed had laid out a plan to wind down QE3. Many said that this was it for the market, people who were long the market were finally going to get crushed. The Dow Jones was only down 25 points yesterday, but surely this is it for the market right? If you read the article, however, it does not really seem like news.

Fed officials could shrink the size of their purchases and hold it at that level for a while as they assess the effects, or they could make several moves in a row if that seemed right. They could also boost their buying if they lose confidence about the economic outlook.

So what should your takeaway from the WSJ article be? Well the Fed remains flexible and is prepared to decrease its bond buying if the economy improves but it is also willing to increase it if the economy falters.

While many are afraid that the end of QE3 will bring about an end to this rally, many have also stated things that are flat out wrong about the effects of QE. An article by Contributor Quoth the Raven he said:

Folks, no bull market lasts forever, and to me, the signs have never been clearer that the floor below us is about to give out. To think we can continue to move upwards the way that we have forever, especially in the wake of how we're diluting our currency, is simply foolish.

It's true. No bull market lasts forever. But the part about us diluting our currency? That is simply not the case.

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This is the trade-weighted dollar average. As you can see since QE1 began all the way back in November of 2008, the dollar has remained largely unchanged. The majority of the move down took place before QE1 was even announced. I think that much of the fear about the end of QE being the start of a market Armageddon is due to the misconceived notion that QE is injecting money into the stock market. I will say that there have been times when the market has been up nine days in a row that it felt that way, but it is not the case. The Fed can't just magically increase the money supply. It needs the banks to lend to do that, which is why we haven't seen much inflation. The Fed has been increasing the money base, but not the money supply, only banks lending can do that. Just like the Fed can't buy stocks, it only makes Treasuries less attractive and encourages investors to hopefully seek yield in the stock market.

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I would also like to add one thing about Gold (NYSEARCA:GLD). Gold would not have fallen so precipitously if people were not worried about deflation. If they were not gold would not be falling like it has this year. Of course Goldman Sachs issuing a recommendation to short and then covering 10 days later hurt the price of gold, so did brokers raising margin requirements to 100% when it crashed, but I still think Gold's fall is fundamentally driven. As Contributor Tim McAleenan Jr. pointed out in his recent article on Gold and Coca-Cola (KO), the biggest problem with gold is no dividends. People who bought gold in the past several years were told by those like Peter Schiff that the investment in gold would protect them when the Fed's policy caused hyper-inflation, then when that seemed unlikely they went to high-inflation, when that failed to materialize, they went to claiming gold would benefit from above-average inflation. None of this happened and the stock market kept rocking and rolling along and those who bought quality stocks that paid dividends were being treated handsomely. I say gold's decline is related to deflation, because many of the people who purchased gold were expecting rampant inflation. Deflation is just a decrease in inflation, or in the case of many gold bugs, in what their expectations for inflation were.

Summing it all up, I believe that the Fed is still a way off, even more so if the dovish Janet Yellen, presumed by many to be the next Fed chair, takes over if Ben Bernanke steps down next January. Of course this is still a way off, but that is the point. I remain bullish through the rest of this year. I might be wrong, literally thousands of things could happen between now and the end of the year that would send the rally off course, but I doubt any of them will materialize. Downside protection is pretty cheap, and in the rest of Quoth the Raven's article he outlines many good ways to hedge, I just think Gold is not a good one for the current market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.