Sinking dollar, rising portfolio

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(Money Magazine) -- When you're traveling abroad, it's easy, if unpleasant, to grasp the impact of a sinking dollar. Now that the euro is at an all-time high against the greenback, dinner for two at a modest Paris café will set you back $200.

When you're trying to decide how to steer your 401(k) or other investment accounts, the implications aren't so clear. But if history is any guide, the dollar's woes will eventually weigh down U.S. stocks. Here's why, and how you can keep your portfolio above water.

Simply put, when the dollar is strong against other currencies, it signifies that our economy is good and the world's faith in the U.S. is high. Conversely, "a weak dollar is a sign that something's wrong," says Gordon Fowler, chief investment officer for Glenmede Investment Management.

The dollar has had declines of 25 percent or more twice in the recent past; the current fall is 36 percent since 2002 against a basket of foreign currencies. In the early 1970s, the peculiar combination of rising inflation and low demand known as stagflation was weighing the buck down. In the mid-'80s, the dollar fell amid fears the U.S. was about to be overtaken by Japan Inc. as the world's economic superpower.

This time around, the reasons for the decline are more subtle. The U.S. economy has been expanding, but that growth has not been spread evenly; now the meltdown in the housing market poses a recession threat.

Moreover, we're running a large federal deficit and a trade gap of nearly $60 billion a month. All of that puts downward pressure on the dollar.

So far that pressure has been beneficial: It's made U.S. goods sold overseas more affordable, helping to cut the trade deficit. And it is boosting the bottom lines of U.S. exporters because their foreign sales are in currencies that are appreciating.

"This is a healthy, corrective development for our economy," says Eaton Vance chief economist Robert MacIntosh. Certainly the stock market seems comfortable with the trend. The S&P 500 has risen 35 percent in the five-plus years that the dollar has been on the decline.

But the flip side of our stuff being cheaper overseas is that imports are more expensive here. And we do like to import. Eventually that means rising inflation. In both the early '70s and mid-'80s, inflation related to a falling dollar led the Federal Reserve to raise interest rates. That stabilized the buck - and sank the stock market. (See the graphic to the right.)

"Whenever the dollar turns, it will probably mark the beginning of the next bear market," says Christopher Orndorff, head of equities for Payden & Rygel, an asset management firm in Los Angeles.

There are scenarios that Orndorff foresees that could allow the market to evade this fate. First, Fed chairman Ben Bernanke could prove more artful than his predecessors at fighting inflation without killing stocks. Or the dollar could strengthen without the Fed's intervention, not necessarily because of good news for the U.S. but because economies in Europe or Asia run into trouble.

There is, however, a longer-term bearish outlook for the dollar too. In this scenario, which Warren Buffett worries about, overseas investors financing our fiscal and trade deficits by buying Treasuries grow impatient with the sinking buck - which, after all, is worth less in their home currencies.

So they sell, and then buy investments in other currencies, further weakening the dollar and forcing up interest rates here. That, in turn, chokes off the U.S. economy, so the overseas investors sell even more, weakening the dollar again. The cycle then repeats. If that's what unfolds, "economic superpower" really will end up no longer being used near the words "United States."

You don't need to buy into doomsday thinking, however, to try to tack your portfolio in a way that limits the damage from eventual consequences of a sinking dollar. Here are three ways to do that:

You can take advantage of a falling dollar by buying foreign stocks. But after a six-year run, international equities aren't cheap. Giant U.S.-based multinationals, which have lagged the overall market since the late 1990s, are a ready-made alternative, says James Stack, editor of the InvesTech Market Analyst newsletter.

An easy way to invest in these stocks is through a mutual fund like Jensen (Charts), a member of the Money 70, our list of recommended funds.

Among Jensen's top holdings are global leaders such as General Electric (Charts, Fortune 500) and 3M (Charts, Fortune 500). Of course, if history repeats itself and the U.S. market sinks once the dollar stabilizes, these stocks could get hit too. But their global dominance and often-generous dividends will help cushion the blow.

Jeffrey Knight, head of global asset allocation at Putnam Investments in Boston, says that investing in overseas government bonds is a "pure play" on the falling dollar since you're betting on the health of economies, not corporations.

And unlike an international stock fund, a fixed-income portfolio such as John Hancock Strategic Income (Charts) is unlikely to fall as hard as stocks in difficult times.

Remember that in the past, the dangerous time for stocks came after the Fed stepped in to curb the eventual consequence of a falling buck: inflation.

Robert Arnott, manager of the Pimco All Asset fund, notes that a simple way to protect your portfolio is to invest in Treasury Inflation-Protected Securities (TIPS). Unlike traditional bonds, whose returns can be ravaged by inflation, TIPS' principal value rises with the consumer price index.

The best deal in TIPS is the Vanguard Inflation-Protected Securities fund (Charts), in our Money 70. It's shelter in a storm, and it comes at a good price.