Is the dollar's comeback for real?

By Tim Middleton

Commodity investors are taking a whipping as prices plunge for everything from oil to gold. The folks who really ought to be scared, though, are shareholders in foreign-stock mutual funds.

Since the end of 2001, foreign stocks have outperformed their U.S. competitors entirely because of the dollar's weakness. The commodity-price rout is both a symptom and a cause of the greenback's sudden resurgence, and a strong dollar spells penury for U.S. investors in foreign developed-market equities.

In short, if you made money in global markets over the past few years, you made it because of the weak dollar. Bail out now, or the greenback will come back to bite you.

That's assuming, of course, the dollar's comeback is real. I think it is, and what we're seeing is the start of a multiyear trend that changes the equation for global markets -- and likely for your portfolio or 401(k).

All about the buck

"If you're going to invest in foreign companies, just be sure you realize that currencies seem to be at least as important as what's going on on an individual-company basis," says famed value investor Ronald H. Muhlenkamp, the manager of the eponymous mutual fund (MUHLX).

Conventional investment wisdom holds that foreign equities play a valuable role in any portfolio, providing excellent returns as well as diversification away from the risks unique to the United States.

As is so often true, the conventional view is wrong. Foreign equities actually underperform the U.S. market when measured in terms of their own currencies. And the benefits of diversifying your portfolio disappears when markets head south. Beta -- which measures how closely markets are correlated, with 1 being perfect alignment -- "approaches 1 in a down market, so the protection through diversification you were counting on isn't there," says Georgia Bruggeman of Meridian Financial Advisors in Holliston, Mass.

If you own a bundle of foreign-stock funds, you are likely sitting on a lot of profits despite the recent bear market. Now is a good time to move money out of them and lock in some of those gains.

Sinking dollar, rising returns

What kind of profits might you have racked up? Between 2001, when the dollar's value most recently peaked against other currencies, and the end of 2007, the MSCI EAFE Index, the standard measure of developed foreign stock markets, surged 223%. The Standard & Poor's 500 Index ($INX), by contrast, managed a gain of 42.4%.

That bonanza, however, flowed only to U.S. investors. In local-currency terms, the EAFE advanced just 36.1% in those six years, less than the S&P.

Why the difference? The value of the dollar shriveled. On a trade-weighted basis, according to the Federal Reserve, it tumbled 18.2% in those years. More particularly, it shrank 39.8% against the euro and 14.3% against the Japanese yen, the two currencies that dominate the EAFE.

One euro was worth 89 U.S. cents at the beginning of 2002. Early this year, a euro bought $1.60. A buck that could buy 132 yen six years ago fetched only 101 at the dollar's low point this year.

Since the dollar's low in April, it has rebounded 6.3% against the euro, as of Aug. 15, and 8.5% against the yen.

These currency swings are nothing new. Muhlenkamp's book "Ron's Road to Wealth" was originally published in 1994, when foreign equities were enjoying just such a currency kick. In the latter half of that decade, however, the dollar rallied, and foreign gains evaporated.

Today, Muhlenkamp, whose fund can own foreign stocks, owns only two: Cemex (CX, news, msgs), a Mexican basic-materials producer, and BHP Billiton (BHP, news, msgs), an Australian natural-resources company. Currencies weren't a factor in his thinking, he says -- only the theme of global demand for resources.

But that boom in commodities has turned into a bust in recent weeks as oil has retreated from more than $140 a barrel to little more than $110 and gold from more than $1,000 an ounce to just above $800.

Continued: Commodities price in dollars

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