TOP STOCKS:Protect Your Portfolio From a Weakening Dollar

There's something lurking out there in the shadows that will likely weaken the dollar -- and your portfolio along with it. Fortunately, there's a way to defeat this dark force.

In March, British Prime Minister Gordon Brown promised to "bring the shadow banking system and tax havens under the regulatory net." What exactly is the shadow banking system, and why does it matter to you?

The Financial Times summarized it nicely: "A plethora of opaque institutions and vehicles have sprung up in American and European markets this decade, and they have come to play an important role in providing credit across the financial system." [Emphasis mine.] These opaque institutions and vehicles have names like "asset-backed commercial paper," "credit default obligations," "structured investment vehicles," and "derivatives." Their role in providing credit in the last decade was substantial. Bob Janjuah, a credit analyst at Royal Bank of Scotland, estimates that in the past two years, the shadow banking system accounted for half of all net credit creation in the United States.

Out of the darkness, into the light
When trust evaporated among participants in this hidden system, the current financial crisis was born. Ben Bernanke likened it to an old-fashioned bank run, telling The Washington Post, "We were seeing variants of classic panic behavior" in 2007 and 2008 when markets for certain asset-backed securities froze.

Having lost their appetite for products like mortgage-backed securities, it seems that everyone is trying to exit the system at once. Economist Paul Krugman points out that, "People aren't pulling cash out of banks to put it in their mattresses -- but they're doing the modern equivalent, pulling their money out of the shadow banking system and putting it into Treasury bills." This phenomenon drove yields on Treasuries down to historic lows, with the three-month T-bill briefly going negative (in effect, a guarantee that the purchaser would lose money on their investment). This flight to safety has led to the dollar's short-term strength.

Slow down -- you move too fast
However, the unwinding of this system means there are now a lot more dollars in the global financial system. Because the shadow banking system essentially found itself in a liquidity trap, the Federal Reserve has flooded the system with dollars to prevent a collapse. However, when confidence returns, investors will want to own something other than Treasuries. The flight out of safety and back into the market will mean a weaker dollar on the global stage.

Now that all these derivatives have come to light, what's the average American investor to do?

Light at the end of the tunnel
I recently asked Foolish colleague Tim Hanson, who heads our Global Gains advisory service, about this very conundrum: how to protect a portfolio against a weaker dollar. Should American investors be satisfied owning stocks of American companies that are seeing large growth from emerging markets, names like Deere (NYSE: DE), General Electric (NYSE: GE), and Yum! Brands (NYSE: YUM)? Or should investors weight their portfolios heavily with foreign companies that trade on U.S. exchanges and generate revenue in currencies other than the dollar?

Tim's answer was, of course, to do both. Own quality American companies -- like Intuitive Surgical (Nasdaq: ISRG), which has already begun to move into the Chinese market, and will see much more growth overseas. At the same time, U.S. names shouldn't be your only holdings in certain sectors like energy, and owning stocks like Petrobras (NYSE: PBR) or CNOOC (NYSE: CEO) can help you diversify your stocks away from dollars exclusively.

Feelin' groovy
But Tim got a serious look on his face and told me that I also can't afford to ignore foreign small- and mid-cap stocks. Sure, there's more risk investing in foreign countries where the rules, regulations, and business conduct aren't always well understood. But with their huge upside potential, foreign small and mid caps might be your best hedge against a weak dollar.

This is why Tim and his Global Gains team are taking a third trip to Asia, on July 5, visiting with business owners and seeing operations firsthand. These companies are operating in dynamic emerging markets and have the potential for super-sized returns, and this could be your best hedge against a weak dollar. If you'd like to learn more about them, sign up to receive all of the team's free real-time dispatches from the field.