The Coming Bubble, and How to Avoid It

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Although it's been barely two years since the last investing bubble burst, there's already another bubble forming.

Don't just take my word for it. Even billionaire investor George Soros agrees. As "the man who broke the Bank of England," he's got a knack for knowing when things are about to head south.

Before we take a look at how you might profit, let's review this bubble's formation.

All that glitters
Over the past two years, Congress spent billions of dollars to jump-start the economy. As we know too well, it funded this effort almost entirely with debt.

That may be good for the economic recovery, but it wasn't necessarily good for investors. As the national debt level rises, the dollar becomes weaker, since currency investors and Treasury bond purchasers shy away from high-debt countries. This, in turn, leads to inflation.

I imagine most investors will agree with that assessment. However, many investors are mistaken in the belief that investing in gold is the best way to counteract this inflation.

The consensus is dead wrong
Gold is a luxury commodity. It has no coupon rate and no growth prospects. Gold can rise in price only as much as demand for it grows.

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

So why are investors still speculating in gold when there are so many unknowns? I suspect it's because prominent investors -- Jim Rogers of Quantum Fund fame, and even top hedge fund manager John Paulson -- are dabbling in gold.

Even the best can be fooled
This copycat behavior may explain why more than $12 billion of new money poured into the SPDR Gold Trust (NYSE: GLD  ) in 2009 alone. And why that fund attracted another $7.6 billion during the first half of 2010, bringing total assets to more than $50 billion.

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

1. When gold demand rises, supply follows suit, which eventually brings gold prices back down.
Fortune magazine reports that gold miners invested more than $40 billion into new projects since 2001, and most "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.

And let's not forget that demand for physical 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. After taxes, you'd have lost money in gold.

No matter how you phrase it, investing in gold doesn't make sense. That's why 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 get the price of gold to rise is to get other investors to buy into the idea and bid up the price -- tantamount to a giant Ponzi scheme. And as we know from watching the unraveling of Bernie Madoff's empire, that can't last forever.

This explains why buying gold today is a horrible decision you should avoid. Instead, let me share with you a few alternate investment ideas you'd do well to explore.

Shorting gold?
There are several ways you can profit when the gold bubble bursts.

Perhaps the most obvious would be to try to short shares of a gold ETF like the SPDR Gold Trust I mentioned earlier.

Or you could purchase a leveraged short ETF like ProShares UltraShort Gold (NYSE: GLL  ) . This will give you twice the return as gold drops -- but it also works on the flipside. If gold rises another 5%, your money in GLL will go down 10%.

But these aren't ideal options, because the returns won't inversely mirror the price of gold, especially when you net out fees. Plus, given the level of speculation in these funds, their prices might stay irrational longer than you can stay solvent.

However there's another option you might be interested in exploring.

Shorting miners
Believe it or not, North and South American gold miner Goldcorp (NYSE: GG  ) had one of the top-performing stocks over the past decade. Its 10-year annualized return was 27% -- more than 1,000% in absolute terms.

Competitors like Barrick Gold (NYSE: ABX  ) and Yamana Gold (NYSE: AUY  ) didn't earn similar rates of return. And the stocks of competitors AngloGold Ashanti (NYSE: AU  ) and Coeur d'Alene Mines (NYSE: CDE  ) fared even worse. AngloGold "merely" doubled, while Coeur d'Alene was down more than 65% over the same period.

Now, I'd be wrong to deny that part of this mind-boggling return was merited. After all, Goldcorp did multiply its revenue a whopping 50 times over that same time period, whereas the other companies didn't even grow sales fivefold.

But regardless, Goldcorp's return is still huge for a company that solely deals in digging up rocks -- and that return's not likely to continue.

My colleague Matt Argersinger recently ran some numbers to see what Goldcorp's business would have to do to merit those same returns over the next decade.

By his calculations, "Goldcorp's annual production would have to increase by 11 times (not happening) or the price of gold would need to rise to $13,100 (possible, but let's get real)."

Don't get me wrong -- I'm not saying you should go out and short Goldcorp simply on these grounds, and I'm pretty sure Matt agrees.

After all, as I mentioned earlier, gold is extremely difficult to value. It might still go higher, even though this move is without merit. What's more, when shorting, your potential losses are infinite. It's much better to be confident in your short thesis.

But that doesn't mean short selling doesn't have a profitable place in your portfolio at a time like this. You stand to make a respectable amount of money by finding overvalued companies that are overstating the success of their business, through legal (if questionable) accounting mechanisms, or even through outright fraud.

That's why I'd like to point you to a brand-new FREE report Matt just co-wrote with leading forensic accountant John Del Vecchio, CFA. It's called "5 Red Flags -- How to Find the BIG Short."

In it, they share 5 key factors to look out for when seeking stocks to short. Even if you're not ready to short stocks today, you'd do well to read through the report to see whether any of the stocks you're long on might be guilty of this questionable behavior.

And if you're interested in specific candidates to short, I'm sure Matt and John will fill you in on some if you stay tuned to their communications.

All you have to do is enter your email address in the box below, and I'll tell Matt and John to send you this report right away.

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

Adam J. Wiederman doesn't own shares of companies mentioned above, nor is he short any of the companies above. The Fool's disclosure policy is outlined here.

Read/Post Comments (13) | 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 August 23, 2010, at 4:10 PM, outoffocus wrote:

    Ok you started off with an argument that would explain why treasuries are in a bubble and then go on to explain why gold is in a bubble. If anything investors have NOT shyed away from treasuries. Whenever uncertainty creeps into the market investors buy up treasuries because despite having record debt, the US is still considered the "safe haven". This leads to people buying treasuries and RECORD LOW YIELDS. Treasuries yields are so low that most investors are actually LOSING MONEY on the transaction. How is that NOT a bubble?

    Why treasuries are in a bubble and gold is not? Gold's rise is based on fundamentals, Treasuries' rise is based on a phony AAA rating. Sound familiar?

    I'll let Chris Barker refute your other arguments. But I don't believe gold will hit bubble status until the treasury bubble pops.

  • Report this Comment On August 23, 2010, at 4:26 PM, rd80 wrote:

    "That may be good for the economic recovery, but it wasn't necessarily good for investors."

    Except the situation for the past year or so has been exactly the opposite. All that money/debt spent by Congress has done nothing for a recovery, but it's been pretty good for investors.

  • Report this Comment On August 23, 2010, at 5:53 PM, kurtdabear wrote:

    You say: "Perhaps the most damning fact is that, from 1833 through 2005, gold and inflation had nearly perfect correlation. After taxes, you'd have lost money in gold."

    If you knew anything about gold, you might understand that that's the beauty of gold, not a criticism of it. It's insurance against inflation caused by irresponsible governments. Silver does the same thing. For instance, if I had saved the pre-1964 silver quarter that my mother gave me for lunch money when I was in elementary school, I could sell it today for enough Fed-inflated $$ to buy the same good quality loaf of bread today as I could then.

    I have gold for the same reason I have homeowners' insurance: I don't want anything bad to happen, but I want to be prepared if it does. I hope never to have to use either one. (But based on history, it's far more likely that U.S. paper money will become worth less (or worthless) than it is that my house will burn down.)

    Finally, gold is a historically and universally accepted medium of exchange that has transcended most human cultures for many millenia. It may not make sense to the man looking down from Mars, but "It is what it is" here on earth.

    When you get back from Mars, perhaps you should read up on Continentals, Confederate $$, Weimar Marks, Zim $$ and the currency of most of the nations of Central and South American since 1833. After that you might be prepared to honestly and sensibly answer the question that one gold-seller asks: "If I offered to give you your choice of $50,000 in gold or U.S. currency with the stipulation that you had to hold on to it for 5 years, which would you choose?"

  • Report this Comment On August 23, 2010, at 7:21 PM, AUricle wrote:


    Let's see: "In fact, the only way to get the price of gold to rise is to get other investors to buy into the idea and bid up the price -- tantamount to a giant Ponzi scheme."

    Aren't those the same mechanics for stock or ANY other paper price 'appreciation'?

    If you want to strip it down to a supply/demand argument, the increase in gold production has, and will continue to lag demand.

    (especially with the Chinese citizenry being encouraged to own gold by it's own gov't )

    That's a far cry from what happens in the U.S. where gold ownership is not only discouraged, but made even more difficult by onerous fees for storage, etc, and panned by every paper pusher from Wall St to Pennsylvannia Av.

    You can't ramp up gold supply like you can with corn, wheat, or most other commodities either. So the 'commodity' pricing model fall short here, too.

    In fact, Central Banks have artifically contained the price of gold by announcing 'sales' of bullion, thousands of tons of it, for years now. Trust me, that bullion never saw the light of day, as those sales were pre-arranged, going to well heeled mid-easterners. Nonetheless,the 'announcement' ALWAYS produced the chilling effect, which was what the BUYERS wanted!

    I'm not even going to rehash the currency debasment that 'kurtdabear' talked about in the above post, or the 'insurance' factor which is as strong as any argument for gold (perhaps the best of all reasons to own gold)

    Throw in geopolitical risk/fear, and the very real spectre of massive financial instability on a global basis (but especially in the West, whose currencies' are the 'standards' of 'value'......(if you say so)....and suddenly the odds of a Dow/gold price 'crossing' are looking better than the odds of a paper 'fix' that any so-called banking authorities have come up with.....(they have come up with a solution, right?)

    If you think I'm talking about getting 'rich', profiting from disaster by owning gold think again. Relatively speaking, my position will offer stability that no amount of burning paper HAS NEVER, and WILL NEVER, be able to match. (OK, I lied about not mentioning the 'insurance' factor.)

    Perhaps Mars will be far enough away to protect your paper............

    Nice hit piece though!

  • Report this Comment On August 24, 2010, at 12:11 AM, shaktipalooza wrote:

    Yes, George Soros famously stated gold was "the ultimate bubble". . . Soon after, the same George Soros rather infamously doubled his Soros Fund Management LLC gold holdings...

    "The $25 billion New York-based firm became the fourth- largest holder in the SPDR Gold Trust, adding 3.728 million shares valued at $421 million, according to a filing with the U.S. Securities and Exchange Commission yesterday. Its investment was worth about $663 million, the fund’s largest single investment, as of Dec. 31."


  • Report this Comment On August 24, 2010, at 9:27 AM, Margret2 wrote:

    Gold is only following the growing government debt bubble in the US and the western world. Do you think all that debt will be paid off very soon, if ever?

  • Report this Comment On August 24, 2010, at 11:46 AM, pawl442 wrote:

    Thank You shaktipalooza , As I was reading this article I too remembered reading that Soros had just made a large investment in gold. He probably did the same thing that AUricle mentions above relating to the Central Banks. Only in this case Soros did it for himself.

    This article also confuses me because I also remember reading and article [(emailed to me) from "The Motley Fool" named "Tomorrow's Parabolic Surge in Gold" (*1) last week saying gold could reach $1650 or greater over the next 18 months. It even offers the reader a place to vote, on if the price of gold would hit $1650 by/before Jan. 2011 or later or never. So which is it?

    Gold has always been a hedge against inflation which seems almost inevitable due to the Fed's overworked printing press of the last 3 or 4 years. My question is, what happens to the price of gold in a global deflationary period? Has there ever been a global deflationary period?

    Here are a few lines from an article concerning Germany's WWI thru WWII monetary problems and the effects of fiat manipulation (*2)

    "Post WWI Germany is a case study in relation to both the negative effects of banking manipulation and printing press inflation on the one hand, and the positive socio-economic effects of sovereign credit

    financing on the other.

    The German nation was very harshly treated by the Anti-God/Christ Bankers (AB's) in the 20th Century. Germany's post WWI experience of inflation and deflation at the hands of the AB's is instructive.

    The AB's use fractional reserve banking and money supply manipulation to steal the wealth of virtually everyone in the world but the AB's treatment of the German people after WWI was particularly unconscionable and brutal. The blatant Allied theft of German national assets under the Versailles Treaty was then exceeded by the avaricious banking fraud, monetary manipulation and printing press inflation perpetrated by the AB's and predatory scheming international financial carpetbaggers after the Treaty was signed. The crime against the German people was egregious."

    To me this sounds almost like what Wall Street has done to the world since the repeal of "Glass/Stegall" up until???? IMHO. Are the working class people around the entire world the next German population, forced to take whats offered because there is no alternative? (save war, but war had just ended. Is war were where headed?) Or are we to become Japan, with 20 plus years of FLAT growth with only a few getting extremely wealthy? Has this what already started? it seems to be so here in the U.S. I don't think there was global deflation at the time Germany experienced it. (please correct me if I'm wrong)

    Today, because of technology all nations are instantly connected. If deflation does start to infect one nation ( industrialized) I fear no one will be spared. The same goes for inflation but I am unsure about deflation and it's effect on gold. I'm assuming inflation occurs first followed by deflation. Gold would rise with inflation BUT would it also deflate with fiat priced goods. Or would even more people/investors or even governments flock to the metal of timeless value? To me this is the dilemma that the markets have been portraying for the past several months.

    *1) By Christopher Barker August 19, 2010... [ ]

    (*2) MONEY: NOW & LATER - Part III (Germany)

    By Ron Chapman

    Apr 7, 2009 - 4:45:00 AM

    [ ]

  • Report this Comment On August 24, 2010, at 4:12 PM, ChrisHastings131 wrote:

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

    Man the dude who penned this is sucking wind now! NEVER short GOLD!!!!!

  • Report this Comment On August 25, 2010, at 12:32 AM, pawl442 wrote:

    Thanks Chris, that does clear up a few things.

  • Report this Comment On August 25, 2010, at 12:50 AM, MyunderratedLife wrote:

    With treasuries paying such low rates, is there any significant reason not to hold dividend-paying blue chips or even cash rather than government debt?

  • Report this Comment On August 26, 2010, at 1:16 PM, EricTheRon wrote:

    I wouldn't be shorting gold until it fell below it's 200-day moving average (when and if it does). Otherwise you are likely to get hurt.

    Gold bullion (not miners) seems to work as a good hedge for bonds, for both inflation and deflation, and certainly for hyper-inflation. The inflation side is obvious, but on the deflation side it mainly works because in the face of a depression governments engage in "competitive devaluations" in order to keep their exports competitive and keep the jobs for those exports. They both intervene in the currency markets and engage in "quantitative easing" to do this, and both tend to cause the gold price to go up in that currency. This happened in the 1930s as well. But there is the possibility that if there were sustained deflation, even gold would join the other commodities in deflating vs. cash. But of course if you're only using it as insurance for your cash and bond investments (10-25% Gold), you probably won't have a problem there.

  • Report this Comment On August 26, 2010, at 1:21 PM, EricTheRon wrote:

    As Colombo so often said "Just one more thing...".

    With other defensive investments like cash and bonds paying so little, there is even less reason not to have a slice of your investments in gold. Gold pays nothing, may even cost you .25/.40% per year for the ETFs, but the insurance on my house also costs me .25% per year and I'm not looking to stop paying that either.

  • Report this Comment On August 27, 2010, at 6:28 PM, rfaramir wrote:

    Someone has to be on the other side of every trade, no? Let it be the author and those who listen to him. Better pricing for us.

    Better still, buy and take physical delivery. That's the only surefire way to smoke out the naked shorts manipulating the market. It's also the free market way, so we're not depending on government agents to prosecute people who may have government backing for their shenanigans.

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