The Dollar Dilemma

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Americans who vacationed in Europe this summer got to enjoy the benefits of a strong U.S. dollar--better rates on hotel rooms, inexpensive meals and luxury gifts that were cheaper than might have been expected. Well, the vacation is over. The dollar's value has been pounded by the euro and the Japanese yen. After showing signs of recovery earlier in the week, the dollar fell sharply against both currencies last Friday on concerns that a spike in the U.S. jobless rate may hurt consumer confidence. If the dollar's weakness continues, it will not only have an effect on your next trip, it could eventually hurt your portfolio.

U.S. corporations such as Gillette, Procter & Gamble and the automakers get petulant about the muscular dollar because it makes American products more expensive around the world.

But the dollar's decline is dangerous. "It is extremely negative from the perspective of U.S. stock and bond markets because we rely heavily on foreign investors," says money manager Mark Lay of MDL Capital Management, based in Pittsburgh, Pa. "The weak dollar discourages foreigners from investing in our markets. And that could have a catastrophic effect." Foreigners hold about 12% of the U.S. stock market, 23% of corporate bonds, and 44% of the Treasury market. That's more than $7.3 trillion of U.S. assets, equal to 73% of America's gross domestic product, according to researchers at Bridgewater Associates, a global asset management firm based in Westport, Conn.

Despite a succession of rate cuts by Greenspan & Co., the dollar remained resilient because investors--both here and abroad--were looking for a speedy turnaround in the U.S. economy. That optimism made U.S. assets more attractive. Now optimism is fading, and foreigners are questioning whether the U.S. is the best option.

We need the world to have faith in our economy. Barring that, you need to dollar-proof your own portfolio. Multinationals could benefit from the weak dollar if there is increased demand for U.S. goods abroad, and earnings would get a boost when overseas profits are repatriated into dollars. "There will be more buying because of better earnings than there will be skittishness about being invested in dollar-denominated equities," predicts Eaton Vance Management's chief economist, Bob MacIntosh.

Investment strategists advise adding some global equity funds to your portfolio. Not only is it a smart way to diversity, but you will be happy you bought some European investments if the euro continues to appreciate. That way, even if hotels and restaurants in Paris are a little more expensive, you will have enough stashed away so the dollar's weakness won't ruin your trip.

Sharon Epperson is a correspondent for CNBC Business News. You can e-mail her at sharon.epperson@nbc.com