Protect yourself from a dollar disaster

Why the dollar will go down

However that all plays out, one thing is certain: The dollar is going to keep falling against foreign currencies.

Reason No. 1: The Obama administration wants a weaker dollar. The administration -- like the Bush administration before it -- wants a weaker dollar because it helps the economy by increasing foreign demand for U.S. goods.

Reason No. 2: Investors are skittish about government borrowing. The Obama administration is spending hundreds of billions of dollars to rescue banks and stimulate the economy, driving up the budget deficit to a record $1.4 trillion in the fiscal year that ended in September. Meanwhile, the Fed is "monetizing" the national debt -- using government money to buy government debt as another way to inject dollars into the system.

Over the long term, these policies are a recipe for ruining a currency. They create inflation or at least worries about it, which erodes the value of the currency. People will sell dollars to avoid the damage. "Monetizing debt historically has always ended in disaster for a currency," Busch says.

Reason No. 3: Interest rates are low in the U.S. compared with the rest of the world. Currency traders know it will be a long time before the Fed starts raising rates, given the high level of unemployment, says Leonard Kaplan, the president of Prospector Asset Management.

This hurts the dollar in two ways: First, investors take their money elsewhere to get higher interest rates. Second, in what's known as the carry trade, investors borrow in the U.S. at cheap interest rates to invest elsewhere. This creates an excess supply of dollars as those investors sell borrowed dollars to invest elsewhere.

Of course, the dollar will bounce around and tick up at times. But overall, the above factors spell doom for the dollar for several years ahead. Merk thinks the dollar will decline 10% a year, on average, against most other currencies for the next several years. Busch expects a 7% annual decline over the next two or three years. And Dickson, at D.A. Davidson, expects an 8% dollar devaluation over the next 12 months.

Here are the five best ways for investors to play this trend:

1. Buy foreign currencies

It's complicated for individual investors to purchase currencies outright. One alternative is to invest in foreign-currency mutual funds playing the weaker dollar trend. Three to consider are the Merk Hard Currency Fund, the Merk Asian Currency Fund (MEAFX) and the Merk Absolute Return Currency Fund (MABFX).

Another option is to go with foreign-currency exchange-traded funds, or ETFs, such as CurrencyShares Euro Trust (FXE, news, msgs), CurrencyShares Australian Dollar Trust (FXA, news, msgs), WisdomTree Dreyfus Brazilian Real (BZF, news, msgs) and WisdomTree Dreyfus Emerging Currency (CEW, news, msgs). Merk advises against exposure to the British pound because he says it faces many of the issues plaguing the dollar.

2. Buy precious metals and other commodities

All of these things are priced in dollars. So as the dollar weakens, they look cheaper, and demand goes up. Plus much of the world is in a strong recovery, so demand for these things is stronger.

Tom Winmill of the Midas Fund (MIDSX) thinks gold, already trading near all-time highs, will keep rising and trade for $1,200 an ounce in the first quarter of 2010. You can get exposure to gold and precious metals through funds like Winmill's or through ETFs or exchange-traded notes such as SPDR Gold Shares (GLD, news, msgs) iShares COMEX Gold Trust (IAU, news, msgs), iShares Silver Trust (SLV, news, msgs) or ELEMENTS Rogers International Commodity Index Total Return ETN (RJI, news, msgs).

3. Buy gold stocks

Winmill likes Jaguar Mining (JAG, news, msgs), a Brazilian company that could increase production by 50% a year over the next two years, in part because it's going back into old mines with newer mining technology.

A classic gold mining play is BHP Billiton (BHP, news, msgs), one of the biggest and more financially disciplined players in the space.

4. Buy companies doing business overseas

Companies making their stuff in the U.S. will see demand increase because of a weakening dollar. And companies that produce abroad can buy more greenbacks when they bring their earnings home. This may seem like a mere accounting adjustment. But in fact they're really getting more money for what they sell -- in dollar terms. So it's meaningful.

Video: Fallout from the falling dollar

Credit Suisse, for example, just upped its earnings estimates and price target for beer can and packaging producer Crown (CCK, news, msgs) in part because of the weak dollar. About 74% of Crown's sales come from outside the U.S.

Some of the other classic plays on this theme are Coca-Cola (KO, news, msgs), PepsiCo (PEP, news, msgs), McDonald's (MCD, news, msgs), Johnson & Johnson (JNJ, news, msgs), Procter & Gamble (PG, news, msgs), Colgate-Palmolive (CL, news, msgs), Caterpillar (CAT, news, msgs), General Electric (GE, news, msgs), Boeing (BA, news, msgs), Intel (INTC, news, msgs) and other U.S.-based manufacturers. (Read "The myth of U.S. industry's demise" for more on this.)

Be careful if you try to play this theme using mutual funds, however. Some foreign stock funds participate in hedging, a trading strategy designed to negate changes in foreign currency compared with the dollar. A few funds that do this, says Gregg Wolper of Morningstar, are Tweedy, Browne Global Value Fund (TBGVX), Mutual European Fund Z (MEURX) and Pimco International StocksPLUS TR Strategy A (PIPAX). These three fund groups also run international funds that do not hedge.

5. Buy bond funds that park money abroad

When you invest in foreign bonds that do not hedge away the currency risk, you're "parking" money abroad. As the local currencies get stronger against a falling dollar, that parked money can buy more dollars, so wealth goes up. Plus the interest rates their money earns abroad will likely be higher than it would earn here.

Any global bond fund that doesn't hedge away currency risk can be used to play this strategy. Arijit Dutta of Morningstar says three of them are the Pimco Foreign Bond Fund (Unhedged) (PFBDX), the Pimco Global Bond Fund (Unhedged) D (PGBDX) and the Templeton Global Bond Fund A (TPINX).

At the time of publication, Michael Brush did not own shares of any stock or fund mentioned in this column.

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