The Coming Bubble and How to Avoid It

You'd think investors would have learned to stop following the herd. No such luck.

Right now, there's yet another bubble forming, and I believe it's just a matter of time before it bursts. But don't just take my word for it. Even gold advocate Barry Ritholtz recently told Bloomberg Businessweek, "Gold fever has risen to the point of excess."

Before we take a look at how to protect your portfolio, let's look at this bubble's formation.

All that glitters
Over the past three years, the government spent trillions 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, especially because currency and debt investors shy away from high-debt countries.

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 little more than a luxury commodity. It has no coupon rate and no growth prospects. Gold rises 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 men'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 the Quantum Fund, and even top hedge fund manager John Paulson -- are fooling around 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. Of course, it doesn't hurt that the price of gold has tripled over the past five years.

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, with most "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.
The most damning fact is that, from 1833 through 2005 (through multiple booms and busts), 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 is a risky measure. As 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, thus bidding 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. Now let me share with you a few alternate investment ideas you'd do well to explore.

Churning out cash
One of the best ways to protect your portfolio from inflation is to invest in high-yield dividend companies. Unlike gold, which has no coupon rate and no growth potential, many dividend-paying companies increase their dividend over time, have stable growth, and strong assets (which are more valuable in inflationary times because 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:

Source: Capital IQ, a division of Standard & Poor's, and DividendInvestor.com.

But that's not the only way to protect your portfolio, of course.

Look abroad
Another way to ensure your portfolio continues growing even if the dollar weakens is by purchasing shares of companies that work largely in foreign currencies. This is what the team of analysts for our Million Dollar Portfolio real-money service is doing. Not long ago, they brought global investing expert Tim Hanson onto the team, and his influence is clear.

He's led the team to purchase shares of small cap Banco Latinoamericano de Comercio Exterior (NYSE: BLX) -- a Latin American merchant bank that stands to profit from the trending growth in trade between Latin America and Asia. If you're nervous about a bank after the downfall that happened in American finance, don't be. Tim says this company's balance sheet "is almost too strong -- meaning it wouldn't hurt to see the company be a bit more aggressive."

He's also watching trends in Chinese agriculture, leading the team to purchase shares of Yongye International (Nasdaq: YONG), a rapidly growing organic fertilizer manufacturer in northern China. Strong historic sales growth for this company is proof that its innovative marketing and distribution system is working. This is cause to celebrate because China's farmers are notoriously slow in adopting new products and methods.

Of course, those aren't the only international companies Tim and the Million Dollar Portfolio team own or are watching closely. To see the other companies, I invite you to join us when we open the doors to Million Dollar Portfolio for the last time in 2010 in a few weeks. For more information, simply click here and drop your email address in the box provided.

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

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Adam J. Wiederman owns no shares of the companies mentioned above. Banco Latinoamericano de Comercio Exterior and Yongye International are Motley Fool Global Gains choices. PepsiCo is a Motley Fool Income Investor selection. Motley Fool Options has recommended a diagonal call position on PepsiCo. The Fool owns shares of Banco Latinoamericano de Comercio Exterior and Yongye International. The Motley Fool has a disclosure policy.