"Newspaper headlines and the television screens give us the short view ... yet it is the profound tendencies of history, and not the passing excitements, that will shape our future." -- John F. Kennedy
If economic history tells us anything about avoiding massive losses, it's this: Don't buy what everyone else is buying.
History is full of supporting examples -- The Dutch Tulip Bubble of 1637, The South Sea Bubble of 1720, Pets.com circa 1999. In one famous case, JFK's father Joe Kennedy knew it was time to get out of the stock market bubble in 1929, after his shoeshine boy gave him stock tips. More recent examples included late-night infomercials explaining how you, too, could make a fortune flipping houses.
Despite the litany of examples warning us to avoid the fray, investors continue to participate in markets in which everyone else already seems to be.
Beware the famous people
So where are the masses putting their money today? Look no further than gold. According to Bloomberg, the SPDR Gold Trust (GLD) ETF took in $4.22 billion worth of new money in the month of May alone, thus increasing its asset base by nearly 10%. For reference, the next highest was the S&P 500-tracking SPDR Trust
In other words, investors put twice as much money into gold than into 500 of the U.S.'s largest companies, which by the way generate actual cash flows, unlike gold. I understand investors grew nervous about Europe in May, but there's something a little off about that two-to-one ratio.
The hedge fund Woodbine Capital's October 2009 investor letter did a superb analysis of this gold rush, which according to them follows all three criteria of a bubble:
- There is an initial, rational reason for a rise in an asset price -- for gold, that's a declining dollar, stronger emerging markets, and the 2008 financial crisis.
- There is one-sided exuberance -- both good and bad news, deflation or inflation is supposedly evidence of gold's benefits.
- Market prices imply virtually no probability of downside risks -- it costs twice as much to buy a September call option 25% above current prices of SPDR Gold Trust ETF than it does to buy a put option 25% below current prices.
Also, according to Woodbine, gold for investment purposes has increased from a 10-year average of 15% of total demand to an astounding 47% in the previous year. In short, it's likely investors, not necessarily market forces (industrial use, jewelry, etc.), that are keeping gold prices lofty.
None of means that the gold bubble is about to burst. The funny thing about bubbles is they can last longer than you expect. I think this bubble, fueled by the hype, could last a while longer. My best advice to investors, then, is to follow our strategy at Motley Fool Pro and simply avoid putting new money to work in gold right now. There's a better strategy to consider.
No single asset works in all types of markets, as gold advocates seem to believe. Depending on your economic expectations, consider diversifying your portfolio across assets that do well in one or two of the following three scenarios ...
You expect inflation and higher interest rates: Treasury Inflation-Protected Securities (TIPS), commodity-based companies like Alcoa
(NYSE: AA)and Potash (NYSE: POT)and strong companies that refinanced their debt during this low-interest rate environment, like AT&T (NYSE: T)or Boeing (NYSE: BA).
You expect deflation and sustainably low rates: Government bonds (both Treasuries and foreign), companies with little or ideally no high-interest debt and some level of pricing power -- think Apple
You expect a weaker dollar: Foreign-based assets and stocks of businesses that do little or no business in the U.S., like Philip Morris International
(NYSE: PM)if you're not opposed to tobacco.
Foolish bottom line
People buy into bubbles for any number of reasons -- the desire to "get rich quick" or to seek comfort and confirmation in numbers (i.e., better to not be wrong alone). Whatever the case may be, you'll live a less stressful life and have a better chance of generating long-term profits from your investments if you avoid investing alongside the masses.
By understanding previous bubbles in history, we can better learn to avoid them and, if we're correct in our timing, profit as they begin to lose steam. One way to profit when a bubble bursts is with options, which we use quite regularly in the Motley Fool Pro portfolio to not only bet against companies, but also generate income from existing positions and obtain better buy and sell prices for stocks we like.
If you'd like to learn more about our strategies at Pro, just enter your email in the box below.
This article was originally published on Jan. 6, 2010. It has been updated.
Motley Fool Pro analyst Todd Wenning knows a lady who's sure all that glitters is gold, and the last time he saw her, she was buying a very tall stairway. He owns shares of Philip Morris International. Apple is a Motley Fool Stock Advisor choice. Philip Morris International is a Global Gainsselection. The Fool's disclosure policy is a golden god!