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 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 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 six 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

United Technologies (NYSE: UTX  )

$64 billion

2.5%

16.2%

66%

1936

McDonald’s (NYSE: MCD  )

$72 billion

3.3%

30.7%

53%

1976

Abbott Laboratories (NYSE: ABT  )

$74 billion

3.7%

9.2%

61%

1926

Coca-Cola (NYSE: KO  )

$118 billion

3.4%

10.1%

48%

1893

Chevron (NYSE: CVX  )

$149 billion

3.9%

11.4%

44%

1912

Johnson & Johnson (NYSE: JNJ  )

$163 billion

3.7%

11.4%

43%

1944

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 doesn't own shares of companies mentioned above. Coca-Cola is a Motley Fool Inside Value selection. Johnson & Johnson and Coca-Cola are Income Investor choices. Motley Fool Options has recommended a buy calls position on Johnson & Johnson. The Fool owns shares of Coca-Cola. The Fool's disclosure policy is outlined here.


Read/Post Comments (11) | Recommend This Article (21)

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 30, 2010, at 8:52 AM, whereaminow wrote:

    You have not proven your case. Is it a bubble or not? You merely point out that it might be a good short term bearish play. That's a wee bit different from a bubble ain't it?

    The one thing you have not addressed, and I would to hear your opinion, is how the desire-to-hold gold affects its price.

    Investors that desire-to-hold have always been the primary source of the gold supply. Notice that I said "supply" and not "demand." See, the crucial difference between gold and other commodities is that the gold supply is almost entirely above ground.

    Now the majority of the article is just silly and repeats fallacies that go back to Plato's New Republic.

    First, it doesn't matter how silly you think gold mining is. Valuation is always subjective and driven by market actors - for gold, for stocks, for water, for everything.

    Second, the fact that taxes hurt the gold hoarder is an indictment of government disincentivizing savings, not an indictment of gold as an investment. You have to pay taxes just to work. Does that make working a silly endeavor? Your wages will not keep up with inflation either, in part because of taxes and in part because of the Cantillon Effect. But nobody claims that working is silly. (Except that British couple making 50,000 pounds per year on welfare, but that's another story.)

    Third, Warren Buffet's quip, while correct, can just as easily be applied to paper currency. Watch:

    Numbers get printed on paper. It gets passed around. It gets put in banks and guarded by men with guns. Then it disintegrates and we do it all over. Anyone watching from outer space would be shaking their heads.

    Except it's not silly, either using paper or gold. Divisibility and fungibility make them useful as mediums of exchange. Neither is silly on those merits.

    What is silly is going against the market's valuations, which is exactly what you are doing. The market chose gold. It was chosen for the two properties above and for two other reasons that paper can't provide: it is durable and difficult to produce.

    Governments chose paper for other reasons, mainly to make counterfeiting easier. I highly recommend the work of Jesus Huerta De Soto and Jorg Guido Hulsmann to understand the historical fight between gold and paper.

    Thanks,

    David in Liberty

  • Report this Comment On May 30, 2010, at 9:14 AM, KFDEKEN wrote:

    Yes, but . . . all of this neglects that gold owns a very long history of holding its purchasing power, longer than any of the stocks that you mention. Nobody I know is suggesting a portfolio of all gold. However, count me in the crowd that says 5-10% gold makes sense, even at today's prices.

  • Report this Comment On May 30, 2010, at 9:43 AM, MoneyWorksforMe wrote:

    Gold may be the next bubble--yes. But not in 2010. With all of this money printing around the world, and the real possibility of inflation-- or worse, stagflation-- occurring here in the states, I only see the demand for gold increasing. You want to be in bubbles as they grow, but extremely vigilante as to when the fundamentals change so you can exit the position with huge profits before the bubble bursts. As the fundamentals continue to change in favor of gold, with the European debt crisis spreading, an ~$1 trillion bail out package, China back in a bear market, and the US growing debt concerns with extremely high unemployment, the price will only continue to increase. When the former issues begin to work themselves out, that's when it's time to sell gold. I don't see that happening for AT LEAST another few years. And if we happen to go into a double dip, retesting the March 09 lows, all equities will perform miserably, even your significant dividend producers. Gold and silver IMO are the best places to be right now.

  • Report this Comment On May 30, 2010, at 9:44 AM, MoneyWorksforMe wrote:

    Gold may be the next bubble--yes. But not in 2010. With all of this money printing around the world, and the real possibility of inflation-- or worse, stagflation-- occurring here in the states, I only see the demand for gold increasing. You want to be in bubbles as they grow, but extremely vigilante as to when the fundamentals change so you can exit the position with huge profits before the bubble bursts. As the fundamentals continue to change in favor of gold, with the European debt crisis spreading, an ~$1 trillion bail out package, China back in a bear market, and the US growing debt concerns with extremely high unemployment, the price will only continue to increase. When the former issues begin to work themselves out, that's when it's time to sell gold. I don't see that happening for AT LEAST another few years. And if we happen to go into a double dip, retesting the March 09 lows, all equities will perform miserably, even your significant dividend producers. Gold and silver IMO are the best places to be right now.

  • Report this Comment On May 30, 2010, at 11:17 PM, atdowney2 wrote:

    What % of population owns gold? of 100's of people I know not 3-4- so a bubble?

  • Report this Comment On May 31, 2010, at 9:46 PM, anuvaka wrote:

    I can't seem to agree.

    Sure this is Not a time to buy gold,(or silver). 2004? with a price of ~$800 Troy was a lot better. This is a time to be slowly selling gold, building a cash stake or a low interest secure investment.

    Will gold rise to fantastic highs? It has twice in the past 2 years. I don't see Gold $2000 happening without a complete collapse of the Euro, and a low value of US Treasuries.

    I believe you should posses hard gold or silver in a trade-able form, but more for a collapse of world economics or dire emergency.

    Gold is a poor investment, must be held a long time, and only gains in a World Crisis situation

    jC

  • Report this Comment On June 01, 2010, at 2:56 AM, strelna wrote:

    I think you miss the point. It's currency. Politicians are debauching the major currencies of the world. That includes the world's reserve currency. That is why nations with growing GDP like China and India, as well as private individuals (like me) are finding no alternative but to diversify their cash holdings into gold. There simply is no choice. Why? Because politicians can't touch its value.

    I share your intention to hold fine companies with good dividends. But it does not escape me that dollars, pounds and euros are going to continue dramatically to lose value. Therefore your investment will lose value. And while your $ dividend will look just the same on paper, it won't buy the same it used to.

    Too many investors do not recognise the deleterious effect of currency devaluation on their wealth - until they take a holiday in a country wih a less bad one. (So far as I know, there is no good one.)

    Bring back the gold standard!

  • Report this Comment On June 01, 2010, at 10:06 AM, zdennis wrote:

    Hmm. I guess I shouldn't be surprised by the response of all the gold bugs. Gold is so hot in people's minds you'd think we were living in Hollad circa the 1630s and it was made of Tulips.

    But the article is right in at least one respect. Its a poor investment because supply will increase. However, Mr. Weiderman is wrong in a completely other respect. Inflation. This whole 'inflation is inevitable' talk is pretty presumptive considering inflation is at an 11 year low and we're still worrying about *deflation*.

  • Report this Comment On June 02, 2010, at 12:39 PM, mhonarvar wrote:

    sure gold may go up another 10-15%...but with so many stocks down 30,40,50% lately - theres more upside in a well researched stock.

    try getting someone to buy your gold...

    if gold is really the ONLY back up currency...do you think having some in a safe or held by your bank is going to do you any good?

    If all hell breaks lose and Dollar Bills become worthless - you going to start shopping with gold coins? good luck with that...

  • Report this Comment On June 02, 2010, at 2:44 PM, KerrisdaleCap wrote:

    The spread between TIPS and treasuries implies an annual inflation rate of 2% over the next 10 years. If anyone's interested, we wrote about it here: http://kerrisdalecap.com/commentary/?page_id=107&pid=131

  • Report this Comment On June 02, 2010, at 11:34 PM, FutureMonkey wrote:

    I'll echo zdennis. In the near term, I'd be much more concerned about the risk of deflation than inflation. Current monetary policy has thus far prevented deflation and if managed properly should offset inflation risks.

    Never understood the gold bug rational. I'd rather diversify into a broad range of commodities for 5-10% of my portfolio than tie up in one metal of subject to irrational market valuation.

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