Image: Composite of shattered $100 bill

We're into the third year of the economic recovery, and stocks are stuck again. The Standard & Poor's 500 Index ($INX) is trading at levels it reached in February; it's been skidding sideways since.

The past five months have brought a series of potential financial disasters. We've seen Arab revolutions, Japanese calamities, a Portuguese bailout, a second Greek bailout, $115 oil, $1,600 gold, and no fewer than two round-trip stock sell-offs of more than 7%.

And now, there's the U.S. debt-ceiling mess -- which is really two issues snarled into a rat's nest of competing ideologies and hard choices. There is the long-term federal deficit/debt problem. And there is the short-term problem of raising the Treasury's borrowing limit by Aug. 2. Failure to do the latter would set off a chain reaction that might have the U.S. defaulting on its debt.

Last week, in "Debt cure is going to hurt," I looked at the likelihood that a deal will lead to years of inflation designed to shrink the nation's debt, similar to strategies used in the past. So far this week, a deal remains elusive, and the probability of default has gone from "no way" to at least possible.

So it's time to look at ways to protect your portfolio from a debt deadlock -- without losing a lot if Congress and the White House manage to do the right thing after all.

Image: Anthony Mirhaydari

Anthony Mirhaydari

The doomsday scenario

Of course, everyone in Washington still swears they want to avoid a U.S. debt default, because the alternative is so dire. Inaction could also shut down parts of the government and lead to a credit downgrade for the U.S.

And all this could also mean a repeat of the kind of panic seen the last time we faced a big financial policy crisis and made poor choices. That, of course, was in late 2008 after House Republicans initially torpedoed a bank bailout and the Bush administration let Lehman Brothers collapse. Congress eventually OK'd a bailout, but the mishandling of that crisis is part of what made the Great Recession so painful.

For investors, the fallout was severe. From the time the extent of the financial mess became clear in late 2008 through the bottom of March 2009, the market lost roughly half its value. Our 401ks and IRAs crumbled. Yes, the market has made most of that back, but we're still struggling with 9%-plus unemployment and halting growth. Trust me, we don't want to go through something like that again. Not with the economy already vulnerable.

But where there was once promise of bipartisan compromise and a $4 trillion budget deal worked out by President Barack Obama and House Speaker John Boehner, R-Ohio, we now see political squabbling and a hardening of positions. Investors are understandably nervous that Washington is playing political games with our fragile economy.

Can the Democrats and Republicans come together to tackle the deficit and raise the debt ceiling, current bluster aside? No one really knows. And that's what makes the situation so scary. We're flying in the dark here.

Preparing for the worst

So what can the average investor do to prepare for the doomsday?

Getting ready is not impossible, but it means using the right strategy in a market where volatility is high and diversification offers less and less protection from market ups and downs. It's about finding new ways to protect your wealth.

That's no longer as simple as moving from stocks to cash, or buying gold. Cash holdings will be slowly eroded by low interest rates and higher inflation, while gold is vulnerable to swings in the dollar and is extremely sensitive to policy outcomes. There also appear to be signs of froth in the gold market -- it might already have gone too high. And as I discussed last week, bonds, another usual refuge, seem ready for a multidecade period of underperformance relative to stocks.

What you need to do, then, is stay focused on the strongest stocks rather than just hiding, while avoiding the weakest and reducing your overall exposure to the market. Here's how I'd go about it.