Federal Reserve, Stock Market and Gold
Based on the October 2013 Market Overview report.
In the previous update we have seen how Federal Reserve's balance sheet grew in the last few years. Now let us look how this growth coincided with increases on the stock market:
When you look at the above graph it would seem almost gratuitous to ask if there is a relationship between the Dow Jones Industrial Average and the Fed's balance sheet. You don't need to be a technical analyst to see that there is indeed a relationship. Both grew at the same time, but this does not necessarily imply that the Fed is solely or even mostly responsible for the growth in the stock market. Nevertheless, its influence on the index can hardly be exaggerated. Part of the stock market's growth may be due to natural market recovery, part caused by the interventionist policies (notice that the growth in the value of balance sheet is not associated with the growth with market value of assets, since they are not marked to market; that is the value of assets held is not adjusted to current market value like in the case of market institutions).
Why is this relevant? It tells us the strength of the dollar system, or actually the strength of the foundation upon which it stands. To put it technically - the economy needs investment demand to grow, or even more simply, it needs money to grow. The sources of that money can be various and the sustainability of growth depends on what those sources are. The best possible source of money to grow is to get money by saving it - that's the natural capital accumulation, which allows the diversion of funds from pure consumption to financing investment activities. Another possible, but unsustainable way, is to have a bank credit expansion to finance growth through debt). This is what has happened after 2001, the economy grew because banks created massive amounts of credit. The end result of this bubble was predictable from the start to many. There was such huge amount of mal-investments that even the banks themselves got into trouble.
After such a downturn (let's say that Lehman's collapse in 2008 was the beginning of the downturn) we could move into phase two which consists of the government funding "growth" through both fiscal stimulus and monetary policy. We put quotation marks on the word "growth" because it is a very slow and often fictitious growth (usually the case with government-funded growth). This is why we can say that the dollar system is in trouble even if the dollar as currency is not doing badly at all in the currency markets. The economy grew, but not as a result of solid fundamentals, but due to the Fed's interventionist policies. That is why gold kept on shining through that period.
Since the economy did not go into full-blown recovery, it is not surprising that the Fed did not back out from these interventionist practices. And the change at the helm should not change this trend either. We do not believe in a permanent (or at least truly sustainable) market recovery without market forces freely influencing the prices. As long as the Fed stays on its interventionist course, we have every reason to believe that gold remains a firm choice.