After some of the best weeks on record for gold were logged earlier this summer, the bears have taken control (at least for the moment) of the precious metals markets. Gold experienced its worst weekly performance in nearly three years, giving up 9% of the 30% it had gained since January lows. Trading as low as $1597 per ounce this morning, gold is struggling to find solid footing under immense sell pressure from technical traders and hedge funds.

The last time gold experienced this kind of downward movement was in 2008 during the heat of the credit and liquidity crunch that struck global equity markets. Understanding the similarities between the current investor confidence crisis and that which occurred in 2008 is quite helpful in gaining some insight into this latest move. Compare the chart from 2008 to the current year chart as displayed below.

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Notice the massive correction that occurred in the fall (October) of 2008. Gold sold off by nearly $200 per ounce in a matter of about two weeks. This happened at roughly the same time as most of the massive losses in stock prices that year, which makes it quite similar to this current sell off. There is clearly a relationship between liquidity crisis in other markets and these catastrophic sell-offs in gold. When we back up and examine the year as a whole, the interconnectedness between gold and equities comes into sharper focus.

What’s the first thing that stands out about the 2011 chart? Perhaps the fact that even with this current correction, gold is still up 20% on the year. This is more than can be said for nearly any other market sector. As this is the case, gold is often the only thing that can be sold at a profit in order to raise cash in times of crisis. For example, if a trader receives a margin call (has to pony up more cash to save a position) in some other market and gold is the only thing in his portfolio that can be sold at a profit, he may well take some of the cash he has made in gold and allocate it to save his other investments from being closed out altogether.

UBS analyst Edel Tully said this morning that Gold is one of the few assets that remains in positive territory this year, in a sense it is one of the last assets standing, and because of this as investors head for cash they sell the assets that have performed. Essentially gold is a victim of its own success as liquidity trumps.

One thing about liquidity crisis corrections like this one is that they are, by definition, limited in duration. As we look back to 2008 it’s important to remember that within 5 months of the October low, gold had gone right back on the charge and surpassed $1000 per ounce. That made for a hansom 30% + profit in a matter of months.

In the long term, gold’s got a few important things going for it. First, sovereign debt risk has not gone away. Second, inflationary pressures are being felt across the globe and most agree that they will do nothing but increase over time. Finally and perhaps most important is that gold is now cheap again. The whole host of buyers for whom $1700+ gold was just too much to bite off have now taken another look at the market. Though a lot of the short term speculators have been pushed out, the long term physical buyers are showing up in force. We posted 250% sales increases here at Merit at the end of last week. Though the lack of consensus about the direction of the market has a lot of investors scared, it’s also made some buyers greedy for the chance to buy cheap gold. At the end of the year, it’s the greedy ones who tend to come out ahead.