i believe so. i've never actually done it with an external, but i think the principle is the same. you'll have to format both drives first.
i think this can be done through the XP setup disc. and you can select which hard drive you want to install XP onto. if it sees your external, then select it and install it there.
i BELIEVE that is how it can be done. but i don't know the specifics, or whether it will even see the external when you reformat everything. so if you try anything, be careful.