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
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.
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
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.
Believe it or not, North and South American gold miner Goldcorp
Competitors like Barrick Gold
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.