Now that the November election has returned President Obama to the White House and left Congress more or less divided as it was before the vote-with a slightly reduced Republican majority in the House and a slightly bigger Democratic majority in the Senate-we move to the standoff regarding the "fiscal cliff."

Here's the background of the current situation: In the fall of 2011, a gridlocked Congress established a mandated across-the-board cut of between $300 billion and $600 billion in federal spending to go into effect next year unless a deal is struck by the end of this year to cut the budget and/or raise taxes.

Given the bitter congressional gridlock, and economists' warnings that such a sudden cut in federal spending could throw the country back into recession, investors are understandably worried about their portfolios.

But a solution may bring a new set of issues. So they also have to worry about how any deal, should one be struck between the two parties, would affect markets and their existing investments.

Most political observers agree that the two least likely scenarios for year's end are a so-called grand bargain in which taxes get raised on the wealthy and cuts get made in social programs and other areas of the budget in a smooth reform that spreads the pain among all or most Americans; or an alternative where both parties stonewall and just let the country fall off the cliff.

Republicans initially took that strategy with the debt ceiling deadline in 2011, but after losing congressional seats, not to mention the presidential race, in an election where exit polls indicated that the economy was utmost on voters' minds, they are unlikely to do the same thing in this crisis, observers said. Some kind of compromise is thus likely, though it may take some time for the two sides to arrive at one.

Given that, what can advisors do to protect clients in these next uncertain weeks and months?

FASTEN YOUR SEAT BELTS
Dave Roda, southeast regional chief investment officer at Wells Fargo Private Bank, tells Bank Investment Consultant that he does not expect Congress and the White House to reach a deal on the "fiscal cliff" before the December 31 deadline, but he is confident they won't let the country fall off the cliff. "They'll pass something to kick the can down the road past the president's second inauguration and let the new Congress deal with it," he predicts. At that point, he expects "some kind of a deal that will involve higher taxes on dividends, capital gains and the top income bracket."

In the meantime, he says investors and their advisors should be prepared for a period of significantly higher market volatility. With that in mind, Roda says he is recommending reducing the amount of risk in portfolios, while doing "staged buying" whenever markets are down and present opportunities.

He's also "trying to capture a large share of cash flow" by investing in dividend-paying stocks — especially those like technology companies, industrials and consumer cyclicals — that are in a position to raise dividends. For the next couple of months, with the fiscal cliff being the "crisis of the moment," Roda says his bank is dollar-cost averaging. As for clients who provide the appropriate documentation, the bank is also offering options-based puts to mitigate downside risk.

In the case of investors with smaller portfolios, Roda urges advisors to make sure their clients have enough liquid assets to be able to "get through the next 18 months without being forced to sell when markets are down" just to meet their living expenses.

Hal Ratner, CIO Europe and head of capital markets at Morningstar, says that things are a "little bit dicey right now." While he says it is "hard to imagine" elected officials allowing the economy to go over the cliff, which would cause a "catastrophic" global recession, he also notes that "We do think there's going to be a game of chicken going on, a little like the 2011 debt ceiling standoff."

In that environment, he suggests, "Just sitting tight on your investments is a reasonable strategy, especially for long-term investors."

Ratner, like Roda, doesn't expect a resolution by year's end, but rather sometime in the middle or end of the first quarter of 2013, after the new Congress is seated and the president has been sworn in to a second term of office.

His colleague at Morningstar, investment management division economist Francisco Torralba, says that given the likely market volatility until a compromise is agreed on, reducing portfolio risk is probably a good idea.

While he doesn't recommend making any short-term moves, he notes that Morningstar's tactical allocation committee is currently overweighting cash and short-term Treasuries, and underweighting U.S. equities, long-term Treasuries and long-term foreign government debt.

Within equities, he says, the committee is overweighting large-cap U.S. equities, which are generally better able to weather downturns. "We are also tilting positively toward non-U.S. equities," he adds — especially European and Japanese equities.

NO PANIC SELLING
Gene Goldman, vice president and head of research at Cetera Financial Group, says advisors report that they are getting a lot of anxious calls these days about the "fiscal cliff." He says that in such situations, "it is important for advisors to overcommunicate."

The key thing, he says, is to try to dissuade clients from getting out of the market in a panic. "You don't want to be too wrong," he cautions. "We think this issue is going to get kicked down the road and eventually resolved. If an investor thinks everything is going to go to hell and decides to get into cash and gold, and then nothing happens, he's lost a lot." His suggestion: "Be defensive about equities, favoring larger-cap companies rather than mid- or small-cap. We have a bias toward dividend companies. And in the fixed-income area, focus on corporates with strong balance sheets."

Goldman also likes municipal bonds. "They've had four to six straight quarters of good performance and with the likelihood of increased tax rates in states and at the federal level, they are going to be increasingly attractive," he explains. And even though he's suggesting caution on equities, he says, "If you see the S&P fall five percent or more, that is a buying opportunity."

Goldman also suggests that advisors check with clients about their likely cash needs over the next year or more. "In specific cases, where people are afraid of a pending layoff, or have some other reason to expect that they will be needing cash, they might want to set aside some income now, rather than having to sell stocks when the market is down later."

Mike Gibbs, co-head of the equity advisory group at Raymond James, says all the doomsday talk about a fiscal cliff is overblown. "We think that at the end of the day, even driving off the fiscal cliff would mean at most a 1% to 1.5% knock on GDP, but even then, we see the likelihood of 2% growth for the year in 2013." His reasoning: "Right now, CEOs are all hoarding cash and not investing because they don't know what's going to happen. But once something does happen, no matter what it is, they will know what the rules are, and then they'll start spending. So it's not really a dire situation." In any event, he adds, "I don't think the government will let this go over the edge. This is all political and it's about negotiating. Meanwhile, the market will be volatile and there will be great buying opportunities as the markets are jerked around."

Advisors, he says, need to "refocus clients on their goals." He says, "The fiscal cliff is a lot of short-term noise." When that noise drives down markets, he says, advisors should encourage their clients to buy into them.