Eur-own Dilemma

By Daniel Kadlec

Ask the average couch potato about the slumping euro, and you'll probably hear all about Svetlana Khorkina's early mistrials on the uneven bars in Sydney. Far more meaningful, though, are the mistrials of the virtual currency that much of Euroland adopted in 1999 to simplify trade and build economic muscle. A spendable euro won't be in print before 2002. Until then, it's a calculation that 11 nations peg their currencies to, and so far it hasn't worked well for Europeans. Underscoring the trouble: Denmark last week elected not to join the Euro union.

Initially, there were grand plans for the euro to replace the dollar as the currency of choice in international trade. That never developed, and now the euro is on a prolonged descent that all but assures it will remain second fiddle to the buck. Why? To stretch an Olympic metaphor, the gold-medal U.S. economy has been sticking the landing for years, while Europe's economy, like Khorkina, has at times stumbled to the mat. The U.S.'s stability has attracted foreign investment at a brisk pace, tending to bolster the dollar.

The intricacies of foreign exchange don't really matter here, but the fallout does. For globetrotting Americans from Barcelona to Bonn, things are 25% cheaper than at home. The strong buck also means that European goods cost less in the States, which helps hold down inflation and interest rates.

But there's a rub. Americans are more tied to the stock market than ever, and most of their holdings are of large U.S.-based companies. As the euro slides, so does the profit picture at those kinds of companies. Why? They do business across the globe. When the foreign currencies they are paid in lose value against the dollar, that translates into lower profits at home.

Last week Kodak warned that the weak euro, coupled with higher energy prices, will mean disappointing earnings this quarter. Its stock plunged 25%. The previous week Intel issued a euro-related warning, and its stock crashed 22%. McDonald's, Gillette and Goodyear have all cited the slumping euro as cause for a diminished-profit outlook. Others will follow.

If you're trying to invest around the weak euro, avoid companies with extensive operations abroad. Those tend to be consumer-product giants like Colgate-Palmolive and Procter & Gamble, typically thought to be defensive investments. Tech stocks fall into the same trap. Even those without European operations aim to benefit from business there. Your salvation may be in oil, natural gas and electric utilities. Although they've run up, these stocks look best from a risk-reward point of view.

So far, the euro's decline hasn't pounded the U.S. market too hard because traders have been focusing on just one aspect of it: vaporized earnings as euros are converted to dollars. But there's a second shoe that might drop. Oil is sky high, and because oil is priced in dollars, the toll has risen way faster in Europe. The spike could trigger a dramatic slowdown that spills across the pond as U.S. earnings erode.

That threat is partly why the U.S. is intervening in the currency and oil markets. But Uncle Sam can't be too aggressive. If the euro rallies, billions in foreign investment would leave, undercutting U.S. stocks. "We're walking a tightrope," says Gail Dudack, strategist at UBS Warburg. And that's why a little caution makes sense.

Go to time.com/personal for more on the euro. E-mail Dan at [email protected] See him on CNNfn Tuesday at 12:20 p.m. E.T.