GOLD REMAINS A PRECIOUS COMPONENT OF A PORTFOLIO

Ionce heard an analyst say that gold should be viewed as an insurance policy, not as an investment. That’s good advice for anyone who is contemplating a position in the yellow metal in 2012. Gold has very little industrial use and yields no return, so its investment credentials are dubious. However, throughout history gold has always been a good store of value – especially in times of credit market turmoil when countries would devalue their currencies in order to monetise their debts. That’s why given today’s massive debt overhang in the G-3 universe, gold remains a crucial component of any prudent investor’s portfolio.

Ironically enough, most investors would be relieved to lose money on their gold positions because that would suggest that the global economy would remain relatively stable, allowing more traditional capital assets such as bonds or equities to perform well. If gold were to suddenly have a parabolic rise it would most likely mean a massive devaluation of paper assets and it is precisely for this reason that investors should maintain their position in gold despite the constant volatility in its price.

Recently, gold saw a sharp sell-off from its all-time highs above the $1,900 level to a low of $1,550. An army of market analysts proclaimed that the bull market in gold was over and abandoned their long-term positions. That proved to be a costly mistake as the yellow metal found support near its 200-period moving average and rebounded to $1,650. The truth of the matter is that gold continues to be in a secular bull market. One of the common characteristics of such markets is that they tend to have vicious sell-offs from time to time to shake out the weak longs. Ultimately gold may hit $2,500-$4,000, but there will be many retraces along the way.

For those who are keen to trade gold rather than just hold it as protective investment, this weekend the US financial blog Zero Hedge discussed an interesting trading idea first developed by the derivatives strategy firm SK Options. The intraday strategy calls for buying the precious metal during the Asian session and then shorting it during the London/North American trade. From 2000 to 2010 such an approach would have produced an astounding 37.46 per cent return turning an initial $100m investment into $2.16bn of capital. What’s remarkable about this idea is that in 2011 it worked even better producing an astounding 143 per cent return.

“As for the reasons for this gross arbitrage – who cares?” writes Zero Hedge. “Is it manipulation? Is it the early Asian buying offset by London pool selling? It is largely irrelevant – the point is that this is ‘the divergence that keeps on giving.’”

I suspect that part of the reason for this remarkable pattern is the persistent buying by the Chinese. China has accumulated a massive war chest of currency reserves in excess of 3 trillion dollars, but with so much of the country’s wealth concentrated in paper assets Chinese authorities are keen to diversify part of their reserves into hard assets. Recent reports have shown that China has imported more than $5.4bn of gold from Hong Kong suggesting that the “Asian bid” is likely to stay in place for the time being.