The Coming Bubble of 2010 and How to Avoid It

Even though it has been barely two years since the last investing bubble burst, bringing companies like American International Group (NYSE:AIG), Fannie Mae (NYSE:FNM), and Freddie Mac (NYSE:FRE) 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, 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 hedge fund manager David Einhorn, 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.

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

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.

Adam J. Wiederman owns no shares of the companies mentioned above. Coca-Cola is a Motley Fool Inside Value recommendation. Coca-Cola and Procter & Gamble are Motley Fool Income Investor recommendations. The Motley Fool owns shares of Procter & Gamble. The Fool's disclosure policy is outlined here.