Panic strikes, and investors sell gold and buy dollars -- yet again

Rattled by concerns about Dubai's debt, investors fled gold for the safety of the U.S. dollar during early trading on Friday. The move comes as the booming appetite for the precious metal among smaller investors has led to near record prices and shortages of American Eagle gold coins at the U.S. Mint.

But as the enthusiasm for gold reaches a fevered pitch worldwide with speculation focused mainly on how high it can go, the sharp drop also serves as a useful reminder: While often thought of as a "safe haven," gold is marked by volatile prices, and it recently sold off sharply when investors truly got nervous.

Indeed, gold fell hard and the dollar rallied during the financial crises this spring. And a similar dynamic could be seen on Friday. The price of gold tumbled 5% in early trading as panicked investors tried to gauge the severity of Dubai's woes. Later, gold cut its losses to a 1.5% drop. The dollar, meanwhile, reversed its long slide, at least for a day.

As some central banks snap up gold and big-name hedge fund managers like John Paulson increasingly bet on the precious metal, investors have debated how much of the gains are the result of fundamentals as opposed to speculation. The conventional wisdom holds that rising prices are the market's verdict on the Federal Reserve's decision to pump massive amounts of cash into the financial markets.

Riding "a Rush with Liquidity"

But others have pointed out that the gains may be part of a self-feeding cycle, with desperate fund managers under the gun -- chasing assets that seem to be rising -- to show performance as the year ends. And despite perceptions of safety, the recent gold rally has also coincided with the purchase of riskier assets like stocks and junk bonds. Previously, gold tended to move in the opposite direction to those risky assets.

More than any hedge on inflation, the current run in gold seems to riding "a rush with liquidity," veteran market analyst Dennis Gartman told DailyFinance in a recent interview. That is, as cash goes searching for higher returns, gold is attracting a lot of that liquidity along with stocks and other rising assets.

The problem for investors, of course, is knowing how to time the end of the party. With no underlying cash flow, gold is notoriously difficult to put a price on. Some value-conscious investors like Warren Buffett have steered clear of the metal partially as a result.

And when gold price reversals do come, they tend to be violent. Commodities often take the staircase up and the elevator down, the old saw goes. While Friday's move may merely have been a few stories down, it should serve as a wake-up call to overconfident investors.

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