The Coming Bubble of 2010 and How to Avoid It

Even though it has been barely two years since the last investing bubble burst, sending the stocks of companies like Allied Irish Banks (NYSE: AIB  ) , Bank of America (NYSE: BAC  ) , and Genworth Financial (NYSE: GNW  ) to their knees, there's yet another bubble forming. And I believe it will burst in 2010.

Just ahead, I'll tell you how to completely avoid it -- and present an alternate investment strategy you can adopt instead of following the crowd into this bubble.

But first, let's take a look at this bubble and how it formed.

All that glitters
Congress is spending billions of dollars in stimulus funds to jump-start the economy. It's funded almost entirely with debt. As the national debt level rises, the dollar becomes weaker because currency investors shy away from high-debt countries. This causes higher inflation, which everyone agrees is coming.

But the consensus right now is that the best way to counteract inflation is by investing in gold.

And the consensus is dead wrong!
The problem with gold is that it's a luxury commodity. It has no coupon rate or growth prospects, and it can rise in price only as much as demand for it grows.

It's also difficult to value. Some believe the price of gold per ounce should match the Dow Jones Industrial Average. Others believe it must reflect the price of a top-tier man's suit. Still others believe it must account for global supply and demand.

In spite of this inherent confusion, many prominent investors -- John Hathaway of the Tocqueville Gold Fund, Jim Rogers of Quantum Fund fame, and even top hedge fund managers like David Einhorn and John Paulson, to name a few -- believe gold can do well right now.

What's more shocking: The recent Value Investors Congress was full of lectures on how to profit in precious metals.

Even the best can be fooled
The average investor is blindly following these noteworthy men. That's why more than $12 billion of new money has been invested in the SPDR Gold Trust this year alone. I'm the first to admit that falling prey to other investors' moves is an easy pitfall -- but it can also set you up for disaster.

So what exactly are all these investors -- and their followers -- overlooking? These three facts:

1. When gold demand rises, supply does, too, which brings gold prices back down.
Fortune magazine reports that gold miners invested more than $40 billion into new projects since 2001, and they "are now bearing fruit." Bullion dealer Kitco "predicts that these new mining projects will add 450 tons annually -- or 5% -- "to the gold supply through 2014, enough to move prices lower." The demand also brings out sellers of scrap gold, which adds even more to the supply.

All this while demand for gold has dropped 20% in the past year.

2. Gold is not just dollar-denominated.
Unlike oil, gold is bought and sold in local currencies throughout the world. The Wall Street Journal reports that "gold remains well below last winter's peaks when priced in pounds, euros, yen, or Swiss francs." This indicates that it is solely Americans speculating on gold's rise.

3. Gold is historically a poor investment.
Perhaps the most damning fact is that, from 1833 through 2005, gold and inflation had nearly perfect correlation, according to Forbes. This means that, after taxes, you would have actually lost money in gold.

Warren Buffett once quipped, "It gets dug out of the ground ... Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

In fact, the only way to make gold rise is to get other investors to buy into the idea -- like a giant Ponzi scheme. And as we know from watching the unraveling of Bernie Madoff's empire, this can't last forever.

No wonder the vice-governor of the Chinese central bank recently announced they would hold off on purchasing gold.

All of this is why buying gold today is a horrible decision -- and why investors would be better off looking elsewhere.

The absolutely best place to be looking
The best way to invest for inflation is to invest in high-yield dividend companies. Unlike gold, which has no coupon rate and no growth potential, you should be sending your investing dollars to companies that pay a dividend (which often rises) and also have both stable growth potential (which also often rises) and strong assets (in inflationary periods, assets are more valuable since they cost more to replace).

Here are five solid candidates that fit that bill, all of which have a long history of dividends -- through periods of inflation and deflation alike:

Company

Market Cap

Dividend Yield

5-Year Compounded Annual Growth Rate
of Revenue

Liabilities-to-Asset Ratio

Dividends Paid Since

Caterpillar

$36.3 billion

2.9%

5.8%

86.9%

1914

Verizon Communications (NYSE: VZ  )

$92.9 billion

5.8%

8.5%

80.9%

1984

Johnson & Johnson (NYSE: JNJ  )

$177.6 billion

3.0%

5.7%

45.0%

1944

Wal-Mart (NYSE: WMT  )

$209.1 billion

2.0%

7.6%

60.9%

1973

Dow Chemical (NYSE: DOW  )

$31.4 billion

2.2%

(3.8%)

69.1%

1911

Data from Capital IQ and DividendInvestor.com.

These are exactly the sorts of dividend-paying stocks that former hedge fund analyst and current Motley Fool Income Investor advisor James Early looks for in his market-beating service. In fact, two of the stocks in that table are official recommendations of his.

In his newsletter, James has put together a "core portfolio" of top dividend stocks, consisting of six dividend stocks he believes every investor should use as a platform to profitable dividend investing. You can see his portfolio completely free, with a 30-day trial to his newsletter as my guest today. Click here for more information.

This article was originally published Nov. 6, 2009. It has been updated.

Adam J. Wiederman owns shares of Allied Irish Banks, but of no other companies mentioned above. Wal-Mart Stores is a Motley Fool Inside Value pick. Johnson & Johnson is a Motley Fool Income Investor selection. The Fool's disclosure policy is outlined here.


Read/Post Comments (7) | Recommend This Article (34)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 07, 2009, at 8:53 PM, globalsailor wrote:

    Unfortunately, as the value of the dollar goes down outsourcing becomes a lot less pleasant of a task as Americans can't pay for Asian produced goods. What about exposure to companies that pay their salaries in American dollars and then sell their goods abroad?

  • Report this Comment On December 07, 2009, at 10:02 PM, TideGoesOut wrote:

    The real question is how to devise a strategy to profit from gold's inevitable decline.

  • Report this Comment On December 08, 2009, at 8:39 AM, TMFDonauschwaben wrote:

    Kickstart70,

    One possible way to profit from gold's inevitable decline is by using options strategies on an ETF that tracks the value of gold. I thought about implementing such a strategy, but our Motley Fool trading rules surrounding the publication of this article makes it difficult for me to do so.

    -- Adam

  • Report this Comment On December 08, 2009, at 9:13 AM, rwgus wrote:

    Gold is a storehouse of value and it is not backed by the considerable debt of sovereign nations, which is why it is rising and will continue to rise (although it has gone too far too fast and is due for a pullback). As soon as the central governments start doing the right thing and quit dropping dollars from helicopters, I will sell gold. Gold is not just denominated in dollars - but that is what I am using to buy it! And yes, historically gold is a poor investment. However, it is an excellent investment when REAL interest rates are negative, like now. I love articles like this, however, because it shows that people still do not get it and gold has much further to rise.

  • Report this Comment On December 08, 2009, at 12:27 PM, zdennis wrote:

    I disagree with some of the things you said:

    1. "Congress is spending billions of dollars in stimulus funds to jump-start the economy. It's funded almost entirely with debt." Some of this is self-funded. That is to say, 95% of TARP will be paid back, and the stimulus/debt investment will be paid back with a stronger economy.

    2. "As the national debt level rises, the dollar becomes weaker because currency investors shy away from high-debt countries." Sometimes they do, sometimes they don't. America is a special place. Really, there doesn't need to be anymore explanation than that. It is, and will be a good investment, and everyone everywhere else in the world knows it.

    3. "This causes higher inflation, which everyone agrees is coming." I certainly don't agree. Frankly I'm more concerned about short term deflation than long term inflation. If you and all your friends believe this, I would happily make some wagers over your predictions. I like taking Fools' money (sorry...that was an awful pun).

    However:

    1. "But the consensus right now is that the best way to counteract inflation is by investing in gold." I've heard some of the tea party types say this. Usually I just tell them to go back to their "compound". Hucksters have taken to the call as well. I agree with you on this point: Gold is either overvalued already or soon will be.

  • Report this Comment On December 09, 2009, at 4:25 AM, Boscobomber wrote:

    Gold will implode like the price of crude last summer. Right now, gold sales are dropping off the shelf at your local jewelers and retail stores. How far it continues to climb is anyone's guess but as soon as Buyers move away from buying jewelry, it will come down. I would bet there's a number of 'players' betting against gold (like they did for real estate & oil) and will reap big profits when gold starts coming down. Where else in the world can you make money both ways?? Whatta country!

  • Report this Comment On December 09, 2009, at 11:23 AM, rwgus wrote:

    Not sure where you are getting your information, Bosco, but that is not what I hearing. In fact, on Friday the US Mint announced that it was suspending sales of its Buffalo gold coins because it could not acquire the physical metal. Add that to India buying 200 tons and the Chinese leadership advising citizens to buy physical gold, and you have quite a demand. It is down in India due to tariffs, but they appear to be unique.

    Gold and bullets are in a definite uptrend.

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