It’s been an interesting time for gold. And that’s not just because its price has crossed the psychologically important US$1,200-per-ounce mark, a resistance point that, once breached, will vault the price of an ounce of gold to US$2,500-US$3,000, according to gold buffs.

More interesting, rather, is the ebb and flow of sentiment being used to validate traders’ enthusiasm for the precious metal, ultimately drawing into question the real value of gold as “crisis insurance.”

Consider the less than stellar returns on gold during the non-inflationary environment of the 1980s and 1990s. During that period, the U.S. dollar was a pillar of strength and gold was met with little enthusiasm. Gold did well in terms of a basket of world currencies; but in terms of the US$, gold was essentially static for almost two decades.

The difference over the past decade has been a general weakness in the US$ and the rise of the euro as a reserve currency — a combination that has changed the perception of how gold is viewed.

Fast-forward to the U.S. subprime mortgage crisis, and we see that the sentiment underpinning gold has been shifting away from the US$. The demarcation line for this position could be found this past April 16, when the Dow Jones industrial average fell by 125 points on news that Goldman Sachs Group Inc. is being investigated for possible criminal infractions.

As fear mounted — note that the Chicago Board of Exchange’s volatility index (symbol: VIX) spiked by 8% during that day — which should have provided fertile ground for gold buffs. But while money flowed into the US$, gold fell over the course of the day by US$24/oz., or 2.1%.

Conversely, when markets were stable, investors were valuing the US$ as an asset. Since the subprime crisis, when the US$ declined in value, markets tended to push up the price of gold to the point that it is up by a staggering 84% over the past three years.

But here’s the question: if the greenback is the world’s reserve currency, it will attract interest during periods of turmoil. But if gold has been disconnected from the US$, does it still have value as crisis insurance?






@page_break@The answer may lie in yet another shift in sentiment. Gold bulls believe that the precious metal is reconnecting with the US$, as suggested by gold’s May 16 record high of US$1,243/oz. — a period in which the US$ was rallying vs the euro.

The bulls may be right — at least, over the short term. If we have entered a period of equities-market malaise driven by global concerns, the US$ will rally. If the shift in sentiment is real, then gold will rally, perhaps even to US$2,500/oz., as some of the more aggressive scenarios suggest. But that hinges on the belief that traders see hard assets such as gold as the only place to hide.

Having said that, be warned that any sizable rally in gold will probably be short-lived. Like any scenario driven by sentiment, there comes a point at which the fundamentals take centre stage — and fundamentals do not favour gold.

Unlike other commodities, gold has few industrial uses. It does not generate profits or pay dividends, as do blue chip stocks; or interest, as do bonds. And unlike guaranteed investment certificates, there is no guarantee on your principal investment.

Furthermore, if traders give up on the macroeconomic fundamentals that underpin capitalism, why would gold have any value? If you really think the world is coming to an end — seemingly the best scenario for gold — wouldn’t you be better off owning a farm?

Consider holding gold through the summer, recognizing that sentiment could shift at any moment. Once we have more clarity on the euro debt crisis, gold is likely to gravitate back to the mean.

If you want to play gold on a longer-term basis, then you would be well served to ignore a directional bias linked to sentimental shifts. If sentiment is really that fickle, it will cause dramatic intraday moves with no clear direction. Translation: increased volatility leading to above-average options premiums.

The one long-term constant is that gold and gold stocks have long been one of the best sectors for writing covered calls or cash-secured puts — sometimes referred to as “underwriting.” Over the past 30 years, options writers have significantly outperformed those who believed in the long-term benefits of “buy and hold” — to the point that options writing has produced returns as much as 200% or more vs simply holding gold or gold stocks.

Nothing has changed for the longer term. Options writing continues to be the strategy of choice in the gold sector — not only on gold stocks, but on gold itself. IE