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Upside of the Euro Crisis

European stocks are cheap, but the big risk is that the euro keeps falling.

It's a mess across the pond. The problems facing Europe and the euro can't be papered over with the rescue package of nearly $1 trillion the European Union cobbled together for Greece, Spain and Portugal. Not only are the "Club Med countries" spending too much, they are not competitive in world markets and have rapidly aging populations that will only deepen their burgeoning budget deficits.

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If these countries still had their own currencies -- the Greek drachma, the Spanish peseta and the Portuguese escudo -- they could devalue the currencies against those of their northern European neighbors and the U.S. dollar. A falling currency makes a country's exports more competitive, and it makes a country more attractive to foreign tourism -- an important source of foreign exchange in the Club Med nations.

But switching from the euro back to former currencies would be a nightmare. Local courts would have to uphold the abrogation of all contracts denominated in the euro, which has been the legal currency for the past decade. If Club Med countries keep the euro, their only alternative is to cut wages for government employees and slash other spending. But I doubt whether they have the will to stick to the austere budgets specified in the rescue package. It's likely that they'll have to reschedule their debts -- and they may eventually restore their national currencies.

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The crisis will force the European Central Bank to keep short-term interest rates low for some time, eventually lowering them to U.S. levels (0% to 0.25%). And I wouldn't be surprised to see the value of the euro fall to that of the dollar or even lower.

Limited exposure. Fortunately for investors, Europe's financial woes have relatively little impact on U.S. firms. Among companies in Standard & Poor's 500-stock index, only 14% of total sales come from Europe. And the figure for smaller U.S. firms is even lower: Just 4% of sales among companies in the S&P 600 index, which is oriented toward small firms, originate in Europe.

Despite Europe's problems, investors shouldn't shun all European stocks. The weaker euro will make European products more competitive in foreign markets. Plus, profits generated in other currencies will translate into a greater number of euros, which means higher earnings for European companies. That's especially true for technology and pharmaceutical firms, as well as companies that sell brand-name merchandise around the world.

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The major reason to hold European stocks today is that they are cheap (see Steal These Deals). The average European stock sells for ten times estimated 2010 earnings, a price-earnings ratio that is 25% less than the average P/E of U.S. stocks. The biggest risk is that the euro keeps falling. Investors might want to protect against that by using a fund that hedges its currency exposure. An open-end fund that does that is Franklin Mutual European A (symbol TEMIX). For a more-diversified approach, consider WisdomTree International Hedged Equity (HEDJ), an exchange-traded fund.

The European crisis will not derail the worldwide economic rebound. Even before its latest problems, Europe was recovering more slowly than other parts of the world -- most European nations have barely bounced off the bottom of their recession lows. In contrast, by next quarter U.S. gross domestic product is expected to exceed the peak it reached in 2007, and emerging-market economies have already surpassed their previous output peaks.

Investors should, however, be cautious about buying shares in companies that serve only the European economy, especially in the southern countries. But world markets are very reasonably priced, especially compared with fixed-income securities that are yielding next to nothing.

Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and the author of Stocks for the Long Run and The Future for Investors. He is a senior investment strategy adviser for WisdomTree.

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