5 Reasons Gold Is The Next Bubble To Burst

John Kenneth Galbraith's indispensable text "The Great Crash: 1929" describes the "basic and recurrent process" of investment bubbles.

IN PICTURES: 10 Retirement-Wrecking Moves A bubble comes from rising prices, whether of stocks, real estate, works of art or anything else. A price increase attracts attention and buyers, which results in even higher prices. Thus, expectations are justified by the very action that sends prices up. The process continues and optimism about the market effect is the order of the day. Prices climb even higher. Then, for reasons that endlessly will be debated, the bubble bursts. (For information about investing into a bubble, read Riding The Market Bubble: Don't Try This At Home.)

These days, the debate has shifted to gold, as worries about future inflation and economic uncertainty again put this precious metal in the spotlight. Investors very well may be in the midst of a gold bubble that is gearing up to burst in the not-too-distant future. Here's why:

1. Gold is not trading off fundamentals. By a recent measure by the World Gold Council, the vast majority of the global gold supply is held in vaults or worn as jewelry. This implies that supply constraints are not an issue and annual gold production levels from major producers such as Barrick Gold (NYSE:ABX), Goldcorp (NYSE:GG) and Newmont Mining (NYSE:NEM) aren't something to be overly concerned about. Additionally, demand for gold in the form of jewelry and industrial production has plummeted in sympathy with the global economic slowdown.

2. Gold is a terrible long-term investment. Gold's last high of just over $825 per ounce in 1980 is equivalent to approximately $2,300 in today's dollars, after factoring in the inflation of this time period. Even with the recent run up, gold falls well below inflation-adjusted levels of three decades ago.

3. Gold does not produce income or perform like other investments. Gold does not pay a dividend like bonds, does not have an income stream like stocks and is not consumed like consumer staples or energy. As such, it only trades on what investors are willing to pay for it. And investors have a history of becoming excessively optimistic and greedy.

4. The recent price run is purely momentum-driven. A December "Wall Street Journal" article stated that the price of gold had risen in 21 of 24 trading sessions. In less than two months, its price had jumped more than 20% after hitting $1,000 per ounce in mid-September. As Galbraith details, expectations (and not fundamentals) are responsible for sending gold prices upward.

5. Barrick Gold recently removed its gold hedges. On September 8, 2009, Barrick Gold, the world's largest gold producer, reported its intent to remove the hedges that protect it against gold price declines. The company is raising $3 billion by issuing shares to pay off the hedges, which very well could indicate reckless bullishness as gold prices peak out.

Bottom Line
As with past bubbles, gold prices still could move significantly higher as the greater fool theory kicks into high gear. Or, economists' worst fears could be realized if the dollar plummets or inflation really takes off. At some point, to return to Galbraith's writing, "The descent is always more sudden than the increase; a balloon that has been punctured does not deflate in an orderly way." Investors would be far better served by buying safer investments such as Johnson & Johnson (NYSE:JNJ) or Exxon Mobil (NYSE:XOM). (Still thinking about investing in gold? Read How do I go about investing in gold?)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!