The gold price has been a constant source of frustration for gold bugs in the second half of 2011. In the middle of a major sovereign and currency crisis in the Eurozone, gold - considered the world's greatest store of value - has been an erratic basket case that has been moving up and down on the back of risk appetite.
So how does an investor understand the gold market and try to profit from it as we embark on a new year? The first thing to address is gold's safe haven status. Since reaching a high just below USD 1,900 per ounce in September the gold price has fallen 15%. This compares with the dollar's performance over the same time period, it has appreciated 7% on a broad-based basis and 10% versus the euro.
The dollar has trumped gold as the safe haven of choice in recent months, but why is the dollar so much more attractive at times of catastrophe? The reason for this is liquidity. The dollar is the most widely traded asset in the world. Most commodities are traded using the greenback; it is still the world's largest reserve currency by miles and the US financial markets still attract trillions of dollars of investment every year. Liquidity is attractive during times of turmoil because if all else fails you need a form of exchange to buy bread and feed yourself if the world's financial system blows up. In that (worst case) scenario then it is likely that more people would accept dollars than say Norwegian Krone, Aussie dollars or even gold.
If the worst case scenario pans out then you would only want to accept currency that you could easily transfer and that someone else would want. Gold bars are difficult to carry around and it costs money to house gold in a vault you may want to go for the easiest options: the dollar.
As strange as it may seem, the US dollar and the US treasury have become the safe havens of choice this year even as the US budget deficit has exceeded USD 1 trillion for the third year in a row and the US Congress still can't agree on how to deal with its massive debt overhang. This leads some to question how sustainable the dollar is as a safe haven.
Gold, in contrast, can't run a deficit and isn't controlled by any central bank or government so it should not be affected by political risk. Also, because gold is a scarce then its value can be semi-guaranteed. So even though gold has underperformed in recent months, it is still up more than 13% since the start of 2012, which compares with stocks - the pan-European Eurostoxx 50 index is down 20% year-to-date. When you look at the gold price over a longer time period then you can see how it straddles both safe haven status and being a risky asset.
But what does the future hold for gold in 2012? To get an idea it is worth looking at gold's performance during the Lehman Brothers collapse in 2008. Back then the gold price fell 30% after peaking just below USD 1,000 per ounce in July, it then fell to just over USD 700 in November. However, from November 2008 to September 2011 the gold price rallied an astounding 70%. That is hard to beat.
So the lessons we can take from 2008 are that gold gets hit along with risky assets when crises rock financial markets, however, the precious metals tend to bounce back quicker and at a more ferocious pace than other asset classes. It was not until March 2009 that stocks finally bottomed. Added to that, gold managed to rally even though the dollar remained strong and continued to appreciate for the first half of 2010.Thus, although gold is underperforming the dollar now, history tells us that it does not do this consistently.
As things stand at the end of 2011 there is no solution in sight for the Eurozone debt crisis. This could keep gold along with risky assets on the back burner. But if there is some breakthrough in the deadlock in the currency bloc: for example, growth picks up or the European Central Bank steps in to act as the lender of last resort, then the gold price may be the first asset class to recover. So gold's erratic behaviour in the short-term may not mean that the long-term outlook isn't rosy.
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