Gold is still a safe haven. Here's why

Here’s a suggestion for those hoping to write gold’s obituary as the “go-to” asset in times of extreme financial distress: don’t.

The precious metal might be down, but it is by no means out. In the past three weeks, gold prices have experienced a wild ride: after soaring to a dizzying high of $1,920 per ounce on 6 September, they crashed all the way to $1,534 per ounce. Yet, the precious metal has already picked itself up and is currently trading at $1,644, aided by a weak dollar.

Various reasons have been ascribed to the recent decline in gold prices: fears of inflation giving way to deflation, especially in developed markets - gold is typically viewed as a hedge against inflation - liquidation by large hedge funds to raise cash to meet higher margin calls or offset losses in financial markets and a strengthening dollar - gold is a safe haven against falling currencies - among others.

It’s not the first time gold has faced such a brutal mauling. Indeed, since its rise from just over $250 in early 2001, gold has bounced back from bigger drops, having fallen 25 percent between May and June 2006, and 27 percent in October 2008.In the short term though, it’s extremely likely that the yellow metal could face further pounding.

Investment guru Marc Faber and the author of the famous Gloom, Boom and Doom Report recently forecast that prices could fall to $1,100 per ounce, but reaffirmed his faith in the shiny metal. Faber has 25 percent of his portfolio in gold. Another gold bull and commodities guru, Jim Rogers, also acknowledged prices could fall substantially in the short term, but added that if they did, he would buy on dips.

Their comments make one thing clear: While gold remains a viable asset, expect more price volatility ahead. The sharp surge in prices over the past two months has been matched by an equally dramatic fall in recent days. What investors need to keep in mind is that gold is no longer a low-risk asset and that it will be affected by extreme bouts of volatility just like other assets.

However, it remains a good bet for investors seeking diversification. Given that other assets such as stocks are still facing uncertain prospects, gold can still limit losses in those assets by moving in the opposite direction. Of course, there are times when both gold and stocks will move in the same direction - as they did recently - but more often than not, they don’t.

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There are other arguments in favour of betting on gold.

One, the growth stories of India and China make the precious metal an attractive investment bet. India and China account for half of global gold demand and, over the past decade, there has been a strong relationship between rising incomes in both countries and gold prices. Small-scale retail investors, in particular, are key bullion buyers, and are likely to remain so. Of course, they may stay wary of buying before prices stabilise, but once they do, expect them to swiftly snap up the shiny metal.

Two, there is little doubt that the US dollar, while currently on a short-term uptrend, is experiencing a long-term decline in value. While the debt troubles in the euro zone have forced investors to dive into the dollar, the greenback has its own headwinds, primarily from a sputtering US economy and a one-notch downgrade in the government’s sterling triple-A rated debt.

Three, there will be more financial crises to come - and gold will be sought as a safe haven, again. Bet on it. The global economy has still not fully recovered from the credit crisis of 2008; policy makers and governments wriggled out of that one with short-term fixes (monetary and fiscal stimuli). Now, three years later, the world is on the verge of another Lehman-like moment; again, governments are seeking short-term cures. A crisis might be averted for now, but it won’t be long before the next one arrives. And gold will become the chosen one again.

Four, big institutional investors like gold-backed exchange traded funds, which buy physical bullion on behalf of investors, have not joined the recent panic selling, suggesting they still believe in the gold-as-an-investment theory. The liquidation is most likely taking place among speculative investors.

In fact, gold remains one of the best-performing asset classes of 2011 and recent falls have only wiped out the gains of August. The precious metal’s price is still 13 percent higher this year.With the black clouds over the global economy still not lifting, don’t expect gold’s safe-haven reputation to die any time soon.