The Coming Bubble of 2010, and How to Avoid It

Even though it has been barely two years since the latest investing bubble burst, sending the stocks of Fannie Mae and Freddie Mac to their knees, there's yet another bubble forming. And I believe it will burst this year.

Don't just take my word for it; even world-renowned investor George Soros agrees.

Just ahead, I'll tell you how to completely avoid it, and I'll present an alternative 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 has spent billions of dollars in stimulus funds to jump-start the economy. This influx of dollars was 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 most 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!
Alas, gold is 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.

Even more shockingly, a 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 financial wizards. That's why more than $12 billion of new money was invested in the SPDR Gold Trust (NYSE: GLD  ) in 2009 alone. I'm the first to admit that falling prey to other investors' moves is an easy pitfall, but it can set you up for disaster.

So what exactly are all these investors -- and their followers -- overlooking? These two key 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 (other than as an investment) dropped 20% in 2009.

2. 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.

Truth be told, the only way to get the price of gold to 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, that can't last forever.

No wonder the vice governor of the Chinese central bank recently announced that the bank is holding off on purchasing gold.

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

The absolute best place to look
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 Dividends

Liabilities-to-Assets Ratio

Dividends Paid Since

Caterpillar (NYSE: CAT  )

$43 billion

2.5%

16%

85%

1914

American Express (NYSE: AXP  )

$55 billion

1.6%

10.4%

88%

1870

AT&T (NYSE: T  )

$153 billion

6.5%

5.5%

62%

1881

Procter & Gamble (NYSE: PG  )

$183 billion

3.1%

12%

49%

1891

ExxonMobil (NYSE: XOM  )

$326 billion

2.5%

9.4%

53%

1882

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 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 no companies mentioned above. American Express is a Motley Fool Inside Value selection. Procter & Gamble is a Motley Fool Income Investor recommendation. The Fool owns shares of Procter & Gamble. The Fool's disclosure policy is outlined here.


Read/Post Comments (15) | Recommend This Article (25)

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 May 01, 2010, at 11:20 AM, TheDumbMoney wrote:

    To the limited extent TMF as a corp is not totally agnostic about catering to every possible passion and investment style, you and Christopher Barker, aka TMFSincharuna, need to TALK.... I like all of the above except for CAT, which has very high debt, and a TTM P/E of over 40, a forward PEG Ratio of 1.9, and a payout ratio of 86%, though that last is likely to drop in the next year, if all goes well.

  • Report this Comment On May 01, 2010, at 3:58 PM, rofgile wrote:

    Good article.

    Let's see what Christopher B. says to this.

    -Rof

  • Report this Comment On May 01, 2010, at 6:27 PM, herky46q wrote:

    Perhaps gold is a bad investment, but it sure is handy for jewelry, dentistry, electronics and other practical uses. Gold crowns are great. Keep on mining.

  • Report this Comment On May 01, 2010, at 8:42 PM, jennifergmd wrote:

    I don't think most people are buying gold as an investment. At least not those who buy gold thoughtfully. If you look at the gold price- it is rising relative to ALL currencies. Do you really think the euro is going to outpace gold? The intrinsic value of all fiat currencies is zero. If you look at the gold price historically, it has risen every time real interest rates were negative. Gold is there to protect against governments that plunder their currency. Gold stocks are how you make the money. With the economy "improving" why is the gold price moving higher and higher? I suggest you study the difference between the physical and paper gold market. The reason so much money is spent for capital expenses in the mining industry because it gets harder and harder to find gold. The easy gold was mined long ago. There are major geo-political risks to the mining industry. Just because gold is found does not mean it will be profitable to extract. What do you think will happen when the average joe decides to start buying gold as security? What do you think the people in china are doing? Honestly- why is China spending billions of dollars looking for gold and silver? I agree solid dividend paying companies are a good investment now. But you know little of which you speak regarding the gold industry.

  • Report this Comment On May 01, 2010, at 8:47 PM, jennifergmd wrote:

    One last point- do you really believe everything you read? Why on earth would china say they are going to buy more gold? That would send the price higher. Do you remember when Soros said gold was the "ultimate bubble?" Then we find out several months later he made a major investment in gold. Do you believe you are savvier than George Soros? Even Buffett did not see the crisis coming. The outgoing Fed vice chairmen admitted they were complacent and caught off guard. Do you think 5000 years of history is not enough support?

  • Report this Comment On May 01, 2010, at 9:41 PM, ckfinance2003 wrote:

    Most people who bemoan having to research and keep track of stocks they want to buy certainly shouldn't be playing the commodity or currency markets.

    The fact that there are constant infomercials either boasting getting rich off buying gold or trying to convice you to sell your old jewelry means I'm staying the hell away from it.

  • Report this Comment On May 02, 2010, at 12:42 PM, jennifergmd wrote:

    Ckfinance-

    Does that mean you stay away from mutual funds? Do you trust investment banks such as Goldman Saks? The point is- there will always be people trying to make easy money off of easy targets. If you were consistent, you would hardly trust anyone (which would be smart). But buying gold is not about making money. It is about protecting your wealth. If you really study the economy and the gold market, I think you will be hard pressed to make a valid case for gold staying below 1000/ounce for an extended amount of time. I personally think it won't happen again. Gold has not risen from 200- 1000 over the last 10 years by chance. There are reasons for it- and being a bubble is not one of them.

  • Report this Comment On May 02, 2010, at 9:06 PM, videophool wrote:

    Gold will be a bubble when the infomercials are selling gold, not buying it. Gold will be a bubble when all of the big investment banks start hawking clever instruments meant to multiply returns on gold investments. Gold will be a bubble when major magazines put gold on the cover asking "how high can it go", and all the talking heads are explaining why it is different this time. In the mean time, the price of gold reflects one thing, the massive inflation caused by loose monetary policy of the fed that has given us the real bubbles of the past 20 years. And by the way, what will China do with all those dollars, buy T-Bills? I reckon not. They will still be buying gold as quietly as possible. I started buying gold in 1998 @$250/oz. My holdings are up over 300%.

  • Report this Comment On May 03, 2010, at 11:21 AM, herbs814 wrote:

    GLD had a breakout above previous highs. And GLD looks even stronger when compared to the s+p.

    S+p looks bearish and GLD should hold up better than the (financial-heavy) broad stock index.

  • Report this Comment On May 03, 2010, at 10:33 PM, jennifergmd wrote:

    Perhaps the only people we should listen to regarding gold would be those who said to buy it at $200/oz a decade ago. They clearly knew something no one else did. If you couldn't predict then what was going to happen a person would have little business predicting where its going to go. And if you didn't predict the current crisis a person stands little change of predicting the next.

  • Report this Comment On May 05, 2010, at 12:54 PM, Z200 wrote:

    Is there a gold bubble? Perhaps, but if it does pop it will be only short term and gold will rise slowly again. The author is on the right track that the market right now is being over manipulated by the government. But I blame the manipulation of the dollar more than gold. Gold simply reflects that. Short term old Gold? I do not know, but long term I am investing in some gold to hedge against stocks.

  • Report this Comment On May 05, 2010, at 1:08 PM, SUPERMANSTOCKS wrote:

    Right now if you look at gold you will see it is worth its weight per ounce in used cars. So for about 1000.00 you can get a used car. Maybe not the one you want but you can still get one. So One Oz Gold = One Used Car. Also an Ounce of Silver ='s a half tank of gas. I can break it down further if you want me too. I will add this much of course and that is just because we are trading sideways does not mean we're in a bubble. Stop pumping fear into the market just so you and the other big rigs can make a fast buck!

  • Report this Comment On May 06, 2010, at 11:08 PM, jennifergmd wrote:

    I would love to see Adam eat his words. He is dead wrong on gold. No coupon- blah blah blah. After todays move up in gold I can buy my own coupon. I will be happy to sell my gold and gold mining stocks as the average person jumps in right at the top (which is a long way off). Gold will be a bubble- but we are not even close to the top. When he writes an article talking about how gold is a good thing to have- that will likely mean the bubble is hear. I trust no one's advice regarding the stock market unless they have consistently made a fortune in good times and bad. Otherwise- mostly hot air.

  • Report this Comment On May 07, 2010, at 11:34 AM, 7351jay wrote:

    Everyone sees the ads for buyers of srap gold. Does anyone here remember the silver boom of '79? The supply of silver went up and the demand went down. It appears that the major demand for gold is one ounce gold coins! I agree with TMF it all going to end.

  • Report this Comment On May 07, 2010, at 2:15 PM, jennifergmd wrote:

    that's the thing- the boom has not arrived. the day you ask 10 people if they have bought gold or silver and 7 or more have said yes- then that is the time to sell. no one has bought gold yet. everyone needs to ask themselves- who is buying it? people who know better. it is not your average person. i ask 10 random people each week who has bought gold or silver. i have yet to hear one person say yes. you guys have no idea what you are talking about. at this point- i would only take advice from people who have correctly called the crash. otherwise- you will get crushed, again. i bet no one here understands the supply/demand issue of silver. every single ounce of silver that is produced each year is used for industrial purposes- never to be seen again. every ounce of silver mined in the u.s. is used to produce silver eagles. silver eagle coins are being purchased at a record rate. so when investment demand surges- that that means that it has to come from somewhere. and every ounce produced from the ground is consumed for industrial uses. so what does that mean? price goes up. time for people to get a clue. and realize that what is happening in greece is going to ripple through europe. this will not be contained. gold is going up against every currency. and has reached an all time high against the euro. wake up people,

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