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Gold may soon break out of its bear market

If ever there was a time to own gold as a safe haven alternative to other financial assets during tumultuous times, there's no time like the present.

Chris Ratcliffe | Bloomberg | Getty Images

Consider the state of the world this week:

Israel is embroiled in a now three-week long and counting uncertain military operation in the Gaza Strip, in which the death toll on both sides is rising.

In the wake of a Malaysia Airlines passenger jet being shot down over Ukraine, the EU and U.S. are considering added sanctions on Russia and could impose level-three trade and financial sanctions, crippling the Russian economy, business and relations with the West.

Iran is still building a nuclear weapon, as talks ensuring a peaceful nuclear program among Iran and six world powers, including the U.S., are further postponed.

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In Nigeria, escalating Boko Haram violence is leading to a series of suicide bombings.

China continues to engage in angry confrontations with neighbors over territorial claims in the South China Sea, including Vietnam and Japan.

North Korea ramps up its provocations, firing an increasing number of missiles in tests on the Korean peninsula, and this week, a military official threatened a nuclear strike on the White House and the Pentagon.

Argentina is on track to default for the second time in the last 12 years.

And West African countries are now imposing travel restrictions to stop the worst outbreak ever of Ebola in Liberia, Sierra Leone and Guinea.

For investors, uncertainty is high and fears are rising about trade wars, isolationist policies, higher energy prices, sanctions and large-scale attacks—all threatening a fragile global recovery.

"While gold benefits from geopolitical tensions, such tensions are usually limited in scope, thus making only a mediocre argument to buy gold. Having said that, I think we are entering an era of increased instability. Such an environment will warrant an expansion risk premium, causing headwinds to most asset prices," said Axel Merk, who runs the Merk Funds, including Merk Gold Trust.

Read MoreWhy gold prices will remain lower for longer

If that's not scary enough, inflation is rising and the Federal Reserve risks falling behind the curve on tightening policy to keep up with rising employment and prices.

"Gold is a great hedge against inflation, escalating geopolitical tensions, trade skirmishes and repeated rounds of currency depreciation," said David Rosenberg, economist and market strategist at Gluskin Sheff.

Perhaps that's why money managers are boosting the bets that gold will rise. The net long position in gold rose last week to 136,120 contracts, according to the Commodity Futures Trading Commission. It was the sixth week of gains in bullish bets out of the last seven weeks.

After a brutal 2013, during which gold futures tumbled nearly 30 percent, 2014 has been strong for the bulls. Gold's first-half rally of 10 percent outperformed stocks, Treasurys and other commodities.

But that rally has been losing steam lately.

Prices slipped from a high of $1,380 an ounce in March to hovering around $1,300.

Read MoreGold faces 'punishment' if US data are strong

So the question is, what's driving the price, and can there be a sustainable bottom?

Reasons for weakness include a strengthening dollar which typically moves in the opposite direction of gold and is trading near a six-month high. Speculation increases that higher interest rates loom as the economy recovers.

Higher rates would encourage investors to flock to other assets that pay income or interest, unlike gold. Gold has also benefited from the flood of easy money and quantitative easing—the Fed's monthly bond-buying program—that has boosted liquidity and diminished the appeal of fiat, or paper currencies.

Still, the believers say there are more powerful reasons gold could move higher.

Namely, lack of faith in the Fed's view of the economy and inflation.

"I think the most interesting sign of a sustainable bottom in gold, from a bear market that is almost 3 years old, was the $41.40 spike higher the day after (Fed Chair Janet) Yellen's June press conference," said Peter Boockvar of The Lindsey Group.

"It was the first time that a market, by way of its response, disagreed with the Fed's assessment on inflation and the state of employment…I think gold bears were reminded by Yellen that while she may have to raise rates sooner than she wants to because of the trend in inflation and employment, she will be so slow in doing so in terms of pace, that real interest rates will remain very negative for a long time to come, and that is the key bullish factor for gold," Boockvar said.

So far, by broad measures that the Fed watches, consumer prices increased 0.3 percent in June after a 0.4 percent gain in May. Stripping out food and energy costs, prices only increased 0.1 percent.

Still there are signs prices in many consumer goods—and inflation expectations—are rising. Food prices have risen over the last few months, with the price of beef at the highest on record.

Read More Is gold on the verge of a breakout rally?

There's solid demand for inflation protection, as seen in a sale of 10-year inflation-linked debt last week at the lowest yield in more than a year. Money has also flowed into exchange-traded funds that hold U.S. inflation-linked bonds. There's also a growing sense that the Fed may tolerate higher inflation, beyond its 2 percent target, in order to meet its goals on employment.

"If the Fed tells you that 2 percent inflate is now viewed as a floor and not a ceiling, I'd be inclined to bet that the 'new normal' in the future will be much higher than that. And gold, in fact hard assets in general, tend to hold their value in these episodes," Rosenberg said.

"I'm tired of the cliché 'falling behind the curve' but the gold market is beginning to call her out and believing that her credibility is at risk. I believe that it's a very good bet that the Fed won't get ahead of this curve and therefore this gold bear market is over," Boockvar said.

Negative real interest rates, or interest rates removing the effects of inflation, are a key reason for the bulls to be buying gold.

"The reason why I like gold in the medium to long term is because we are going to have negative real interest rates as far as the eye can see," Merk said.

Even people who are neutral on their position on gold, such as Nick Colas of ConvergEx, say gold is worth buying here.

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Colas points to "Indian economic fundamentals improving and margin gold demand should improve along with them. Gold is an important store of value there, so any incremental income tends to find its way (at least in part) into gold."

He also noted that financial buyers are upping their stakes, namely in ETFs like the SPDR Gold Shares Trust and the iShares Gold Trust. "Money flows into these products are consistently positive this year and up $400 million for the year as a whole," he said.

Beyond the ETFs, gold miner stocks may be attractive, even with a strong run-up in prices this year. "The gold miners seem to be learning the lesson from the airliners—abandon the decades of destroying shareholder capital and focus instead on cost control, production discipline, capacity reduction and merging operations," Rosenberg said.

He also notes that the gold stocks tend to lead price of gold historically, which may be further proof that gold has indeed bottomed.

—By CNBC's Sara Eisen

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

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