(MONEY Magazine) – FINANCIAL MARKETS GOT JUMPY IN MAY AS INVESTORS debated whether the U.S. economy was growing too hot or too cold, whether interest rates were too high or too low, whether stocks were about to rebound from their spring swoon or fall another 10%. It's interesting (and mildly disconcerting) talk, but if you've got a long-term horizon and a diversified portfolio, you can tune it in or out as you like.

There is a concern, however, that you do need to be aware of, especially if you have a long-term outlook. And that's the future of the dollar. Its position as the world's preferred currency is a big plus for your standard of living and your investments. Unfortunately, some of the best financial thinkers around, including Warren Buffett, are worried that the buck, down 27% against the euro since 2002, will soon fall from grace in a way that will make recovery very hard. Now, Buffett has fretted about, and bet against, the dollar before.

But at Berkshire Hathaway's annual meeting in April, he announced that his company would pay $4 billion for Israeli toolmaker Iscar, its first overseas acquisition, in part because of his fears about the dollar. "My views on the likelihood of the dollar weakening are as strong as ever, perhaps a bit stronger," Buffett said. Pimco's Bill Gross, who manages the world's largest bond fund, and renowned strategist and author Peter Bernstein have also warned clients that the dollar's decline of late could presage a long-term rout or a period of severe volatility that leads to higher U.S. inflation and interest rates. Here's why that might happen and what you should do about it.

"Squanderville" The problem: Americans--both individuals and the government--are gluttonous consumers and poor savers. Buffett calls the U.S. "Squanderville." The federal government spends $300 billion more a year than it takes in from taxes. To finance all that excess spending, the U.S. sells Treasury bonds. Meanwhile, in 2005 we bought $725 billion more in goods and services from foreigners than we sold to them, leaving overseas companies and governments swamped with dollars, many of which they invested in Treasuries. In fact, because American families and corporations don't save enough to buy all the Treasuries the government churns out, nearly 50% of outstanding Treasury bonds are held by foreigners. To date that hasn't been much of a problem.

But two recent trends are cause for concern. First, the trade deficit remains stubbornly high despite the falling dollar; perhaps the world will choke on dollars. Second, Europe and Japan are raising interest rates, making their bonds more competitive with ours. Result: Overseas investors have less appetite for the dollar, and traders have begun betting against it.

That's not necessarily bad. If markets react calmly, the dollar will drift down, and then the benefits of the decline will kick in. A falling dollar, after all, is good for U.S. manufacturers; it makes our stuff cheaper compared with foreign makers'. "A weak dollar makes us more competitive, not less," says strategist Ed Yardeni of Oak Associates, a money-management firm. If Yardeni's right, corporate earnings go up, growth continues, the dollar strengthens.

What's to Worry? That's the textbook course of events. The fear among Buffett and other dollar bears, however, is that our debt levels are so high now that the correction will be anything but normal, proceeding instead along these lines: The dollar is dropping, making Treasuries worth less to foreigners. So they sell, and buy other currencies, further depressing the dollar. Desperate to retain investors, the U.S. boosts interest rates. But as rates rise, American consumers and businesses, and the government, cut back on borrowing and spending, which slows economic growth, hurts housing prices, lowers corporate earnings and depresses stocks. Overseas investors react by selling U.S. stocks, real estate and still more Treasuries, and by dumping more dollars. The cycle repeats.

"What I am concerned about," says Bernstein, "is people in other countries and even in this country reaching a point where they say the dollar is not only valueless, it's nothing. Then the decline becomes very abrupt. There's no time for adjustment, interest rates go through the roof, and everybody gets hurt."

Now, Bernstein, to be sure, isn't saying this will happen, only that you might be wise to hedge against such a calamity. Buffett, for his part, seems certain that the dollar will fall precipitously; he's just not sure when. Gross envisions violent upswings and downswings in the buck, threatening economic growth here and throughout the world. All of which leaves you with an urgent question: How do you protect yourself without investing as though Armageddon is imminent?

• FOLLOW BUFFETT He says the best way to play a long-term dollar decline is to invest overseas. Gross is of the same mind. It's not so easy, though. Overseas stocks have flourished and are no longer bargains. Besides, European and Japanese multinationals sell so much here that their stocks might suffer if the dollar craters. Gavin Dobson, a strategist at Oppenheimer Funds, suggests instead buying the stocks of small foreign companies that sell little to the U.S. Their fortunes won't be affected by a dollar dive. The MONEY 65's T. Rowe Price International Discovery fund (PRIDX) is a solid choice here. Note that "small" doesn't mean emerging markets stocks, which are tied to commodity prices and have fallen hard of late.

• BUY EMERGING MARKETS DEBT Emerging markets bonds, on the other hand, are now a favorite investment of Robert Arnott of Research Affiliates. They often pay two percentage points more in interest than debt back home, and Arnott thinks rising prosperity around the world lessens their riskiness. The Pimco Emerging Markets Bond fund (PAEMX) is up 17% annualized for the past five years. For a less concentrated approach, the Templeton Global Bond (TPINX) fund has 15% of assets in emerging markets. It returned 13% annually for the past five years.

• REDISCOVER LARGE-CAPS Big U.S. companies often get 40% or more of their sales overseas, and their earnings are boosted by a weak dollar. Yardeni likes materials, energy and industrial stocks, even though they've soared during the past couple of years, on the theory that the global boom will continue. T. Rowe Price New Era (PRNEX), a MONEY 65 fund, invests in these kinds of businesses. If you buy individual stocks, check out Michael Sivy's take on three falling-dollar beneficiaries (page 62). Finally, an S&P 500 index fund will give you exposure to a broad range of U.S. large-caps, including many that look undervalued today.

WHAT A FALLING DOLLAR MEANS TO YOU

Import prices will rise, but foreign investments may benefit, as the past four years have shown.

The dollar is down 27% against the euro and could fall further.

-27%

That may hurt your standard of living as prices of imports rise.

Change in gas prices +75% in euros

+100% in dollars

But it could magnify your gains from overseas investments.

Gain in European stocks

+25% in euros

+71 in dollars

NOTES: All numbers cover June 2002 to May 2006. European gas prices at the pump reflect an average of prices in Belgium, France, Germany, Italy and the U.K. European stock returns based on MSCI Europe index.

SOURCES: Bloomberg, Energy Information Administration, MSCI.

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