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.

First, take control

There's no denying that this is a difficult environment. Volatility is on the rise, which makes trading a harrowing task for even the most grizzled veteran. But correlations are also on the rise, which means that different assets -- precious metals, stocks, corporate bonds, commodities, crude oil -- are increasingly rising and falling together.

So not only does the market feel more dangerous, it's harder for investors to diversify, relying on a wide variety of investments to smooth out the ups and down in their portfolios.

Correlation of crude oil to S&P 100 Large Cap Index © MSN Money

The chart above shows how crude oil futures and the S&P 100 Large Cap Index have been moving in lockstep over the past three years. Before, they moved to their own drumbeat. (The way the chart works, the higher the correlation number, the more oil and stocks are moving together.) When that happens, there is no diversification benefit to be had by holding both in a portfolio. The team at Credit Suisse notes that it's the same story with U.S. stocks versus foreign equities and stocks versus commodities.

This combination of unpredictable political risk, increased volatility and tighter correlations across asset classes is a toxic one.

We have a situation with two possible outcomes: We default and get a downgrade (and everything falls apart) or we get the budget under control and raise the debt ceiling (and the specter of default passes, with stocks and other risky assets blasting higher). There really isn't a middle ground. And with all those assets moving together, you can't hedge your bets.

SLV – iShares Silver Trust © StockCharts.com

A great example of this can be seen in the way silver imploded in May, after the U.S. dollar spiked after the killing of Osama bin Laden. Suddenly, it felt like America had gotten its mojo back. Global financial markets responded by sending the dollar higher, ending a four-month downtrend.

For most of us, it was all good. Bin Laden was dead. We felt a surge of pride and patriotism. Gas prices dropped. And inflationary pressures cooled, thanks to a stronger dollar.

But because the dollar has a close relationship with risky assets, Wall Street panicked. Silver and gold fell first -- followed by crude oil and a long list of other commodities, including industrial metals and copper. Then foreign stocks. U.S. equities came under pressure in June. And finally, corporate bonds suffered a dramatic sell-off on June 16 that marked the end of the drop.

So you can see, there was no place to hide. The selling pressure unleashed by currency fluctuations spread through the system like wildfire. Diversified or not, people got burned.

No more buy and pray

My point is this: The investing environment has changed. Decades ago, when correlations were lower and diversification more powerful, buying and holding a range of investments was the way to go. It paid off over time. And this is still how a lot of people run their retirement investments -- buy and hold, or even buy and forget.

But the advent of a more integrated global financial system has reduced the protection offered by owning bonds and dabbling in commodities along with owning stocks. Just when people need protection, it's harder to find in the traditional places.

The intriguing news is that while correlations are on the rise among asset classes, we're seeing a drop in correlations within the stock market. Simply put, certain areas of the market still outperform other areas on a regular basis. As a result, investors can diversify by regularly moving into areas of the market showing strength and leaving those showing weakness.

In other words, investors need to refocus on good old-fashioned stock selection -- especially in an environment of extreme political and economic uncertainty.

That's because it offers the best result no matter what Washington does on the debt ceiling: If Obama and the Republicans do the right thing, the strong stocks will lead the way; if they don't, strong stocks will fall the least and give you time to get out.

Green means go

They key is focusing on the sectors showing strength. At the same time, by focusing on where the action is and shedding underperformers, you can reduce your overall stock holdings while keeping pace with benchmarks like the S&P 500. Because you're not putting capital into underperforming sectors, you can maintain a larger cash reserve without missing out if the market takes off.

Easier said than done, right?

To help you along, I want to share one of the tools I created for the benefit of my newsletter subscribers: A collection of charts showing the performance of major sectors versus the broad market. You can access it for free at stockcharts.com.

Here's one chart, tracking energy against the S&P 500:

XLE: $SPX © StockCharts.com

The setup is a bit technical, but the display style makes it simple to see strength and weakness. You invest in sectors only when they are demonstrating outperformance via the following conditions:

  • The price bars (shown above in green, blue or red) are green.
  • The price is above the nine- and 18-day moving averages.
  • The nine-day average is above the 18-day average.
  • The MACD indicator in the lower pane is above the zero line and rising.

I also like to focus on sectors where relative price is pushing on the upper Bollinger band (which is the shaded gray area). The chart above illustrates how the energy sector is on a buy signal right now, as it meets all the conditions. A buy signal was triggered in the first week of July.

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Based on these criteria, the tool would have investors focused on energy and technology stocks this month while avoiding transportation, health care and industrials. Here's the month-to-date performance of these sectors, represented by exchange-traded funds:

  • Energy Select Sector SPDR (XLE): 5.3%
  • Technology Select Sector SPDR (XLK): 4.3%
  • Health Care Select Sector SPDR (XLV): -1.4%
  • iShares Dow Jones Transportation (IYT, news): -2%
  • Industrial Select Sector SPDR (XLI): -2.8%

For reference, the S&P 500 was up 1.1% over this period.

Using this strategy has helped the Edge Portfolio (which I maintain for my subscribers) post a 14% gain over the past three months versus a 2% loss for the S&P 500. It works.

Advanced investors and traders can take the strategy one step further by scouring for the strongest stocks within the strongest sectors. In energy, two examples I've recommended to my newsletter subscribers are SandRidge Energy (SD, news) and Hyperdynamics (HDY, news), which are up more than 9% and more than 23%, respectively, since adding them to the portfolio earlier this month.

Hyperdynamics is also being tracked in real time hereas part of my sample portfolio for MSN Money readers.

Summing it up

There are three takeaways here. The first is that the market is becoming a dangerous place, with higher volatility, political uncertainty and more extreme potential outcomes. The second is that the usual safe havens like bonds and gold aren't as safe as they might seem. The third is that a strategy of narrowing your focus to the strong areas of the stock market seems like the solution.

Yes, it will be more work than holding on. We won't be able to let our 401ks and individual retirement accounts sit still. But I think the rewards will justify the effort, especially in these uncertain times.

Even if the debt ceiling ignites another panic, carrying a cushion into the event, courtesy of the gains in tech and energy, gives us the luxury of staying invested -- and preparing for the epic market rally that should follow an eventual political compromise, even if it comes at the last minute.

At the time of publication, Anthony Mirhaydari owned or controlled shares of Hyperdynamics. He has recommended Hyperdynamics and SandRidge Energy to his newsletter subscribers.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.