After hitting the September high, prices have slid dramatically lower and tested support just above 1,500. We have been watching gold prices closely as it now consolidates between support at 1,600 and resistance at 1,700. The reality is that the rally, which started in August, was unsustainable and most gold analysts were expecting the bubble to burst and many now see this price recent as a new entry point for investors who still want to take advantage of this trade.

Despite the strong selloff last month, we can see in the chart that the price continues to maintain its long-term uptrend. A break below support at 1,600 with strong volume would break the uptrend and if that happens then the gold bulls might be in trouble.

To understand where gold prices could go in the next few weeks, it is important to understand why prices have reached almost $2,000 an ounce. The $2,000 area has been an important level in the last few years because it represents the all time inflation-adjusted high. Uncertainty about the global economy has been the biggest driver for this precious metal. Investors have been jumping into gold because of its perception that it is a world currency. Similar to the U.S. dollar and U.S. treasuries, investors have treated gold as another “safe haven” investment.

Investors haven’t been the only ones to hedge their capital with gold; since 2009 central banks around the world have been net buyers of gold, which has added to the strong momentum. Emerging market central banks were the first to start buying gold but major central banks are also starting to buy more gold. According to the Financial Times, the European Central Bank has recently jumped on the gold band wagon and was net buyers of gold for the first in about 40 years.

Some analysts could be a little bit cynical and point out that the ECB was a little late to the party as prices dropped significantly but it does raise an important question as to how resilient gold prices are. The big test for gold will come this week when European politicians are expected to present their plans on how to resolve the latest financial crisis. If the market thinks that the politicians have a grasp on the economic problems than we could see prices quickly drop below as investors feel more confident taking on more risk.

But does that mean the bubble has burst? Although the “safe-haven” trade has been the main driver in the last few years, gold is actually a very versatile investment. Long after this economic crisis people will still be buying jewelry and using gold as a currency. In fact most analysts have been predicting that central banks will continue to buy gold in the next few years as they diversify away from the U.S. dollar.

It is important to remember that gold is an extremely volatile security. In March 2008 after prices broke above $1,000 for the first time, prices dropped to a low of $681. That represents a correction of almost 32%. However that drop did not last long and looking back it was a great entry point for long-term investors. “Gold continues to remain volatile, but has rewarded investors that stayed with the safe-haven metal over the past decade,” wrote Eric McWhinnie, chief commodities analyst at Wall St. Cheat Sheet, in a recent report.

The sell-off in September only represented a drop of about 20%, so we can’t rule out higher prices in the long-term. Traders should pay attention to the volume during the next few days as that could provide some short-term

Click on image to enlarge!

For more updates from Greg, be sure to visit his blog at TheTradingZone.com