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Talk about sticking your head in the sand.

Everybody is worried about the possibility of our squabbling, self-interested politicians in Washington pulling a Thelma and Louise and driving the U.S. economy straight off a fiscal cliff in 2013 and into a new recession. Goodbye, 2% GDP growth. Hello, -0.6%. The U.S. economy in 2013 would look like the eurozone does currently.

But Wall Street is dealing with that possibility in one of two ways:

● By pretending that it won't happen. (Yeah, and Congress didn't sink the U.S. credit rating in an avoidable battle over the debt ceiling.)

● By hoping that derivatives purchased for portfolios will provide insurance against the disaster. (Yeah, derivatives work really well when everybody wants to get on the same side of a trade.)

So instead of those options, let's take a novel approach in this column and actually talk about something you can do over the next few weeks and months to make the fiscal cliff, if it does happen, less painful and to make a nervous market, if the cliff begins to loom dangerously near, profitable to your portfolio.

I'm not going to pretend that this is a grand solution. I'd be quite happy if you called it a partial solution or even a baby step toward a solution. But this isn't my last word on the subject, and we do all have to start somewhere, right?

Jim Jubak

Jim Jubak

My solution? Dividends.

Today, I'm going to explain why creating a watch list of stocks with potential 5% (or better) dividend yields, putting away cash to buy those stocks if they hit my target (and I'll explain what that is), then buying in the confusion and chaos of any run-up to the fiscal cliff is a smart long-term strategy.

The time bomb ahead

Just in case you've been asleep and missed all the references to the fiscal cliff, let's review what it is and why it's a big problem.

It turns out that Congress and the president, probably without intending to, have turned the end of the year into an economic time bomb. Just on the tax side, on Dec. 31, 2012:

  • The temporary Social Security payroll tax cuts expire.
  • The alternative minimum tax will begin to take a bigger share of income.
  • The Bush administration tax cuts come to an end.
  • New taxes required to pay for the Affordable Care Act (aka Obamacare) go into effect.

In more specific terms, the lowest income tax rate would go to 15% from 10% and the highest rate would climb to 39.6% from 35%. (The 25%, 28% and 33% brackets would go to 28%, 31% and 36%, respectively.) The tax rate on dividends would climb to match the rates paid on ordinary income, from the current 15%. Most capital gains would be taxed at 20% instead of the current 15%. According to the Congressional Budget Office, taxes would go up by $347 billion in 2013.

Further, over on the spending side, a deal put together as a way to get the U.S. debt ceiling increased would require automatic cuts to the military budget and more than 1,000 other government programs. Defense would take a 9% cut, and most nondefense programs -- Social Security, Medicare and Medicaid excepted -- would get an 8% shave. Medicare would take a 2% cut.

The total effect in 2013 would add up to $600 billion, according to the CBO. Real economic growth (that's growth above inflation) would fall at an annual rate of 2.9% in the first half of 2013, and the unemployment rate would climb to 9.1%, the CBO estimates. Stocks could fall by 20% or more. (Any estimate of the dimensions of a stock market decline is pretty much guesswork. But I think it's safe to say the results wouldn't be pretty.)

The extreme nature of these consequences is, of course, why many on Wall Street argue this scenario will never happen. Knowing that doing nothing, or doing the wrong thing, would have such dire consequences means that politicians in Washington will never let this come to pass, the argument goes.

I think that view ignores the very real possibility that the November elections will push one or both political parties into a position of "Damn the consequences; let's just bring it all down and blame it on the other party."

And besides, we don't have to actually go driving off the fiscal cliff to do real damage to the economy and the stock market. Even a hint of it could paralyze capital spending and consumption decisions. And it wouldn't take more than a few days of the talking heads on TV panicking at congressional inaction to send the market into a serious retreat.

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