I live in hurricane country and have personally witnessed my share of Category 3s, as well as a handful of tropical storms. One main point safety officials stress is concerning the eye of the storm. Although it brings a relative period of calm, depending on how big the eye of the storm is, you’re warned not to go outside as the eye passes. Once the eye passes and the winds shift, the damage from the second half of the storm can be much worse. 

If the European debt crisis could be compared to a hurricane, then we could say the past two years and resulting band-aid “solutions” have been the first half of the storm — bringing us to the relatively calm “eye” of today. 

#-ad_banner-#The next two years could be much nastier.

An avalanche of debt rolling over…
One European issue you don’t hear about a lot is the massive amount of debt, both public and private, that will roll over (i.e. need to be refinanced) in the next few years. This year alone, nearly $1.2 trillion of European sovereign debt (government bonds) will need to be refinanced. A few weeks ago, in a CNBC interview, CEO of money management giant Blackrock (NYSE: BLK) Larry Fink, hinted that his firm’s clients, typically large institutions, had very little interest in buying those bonds — especially those issued by downtrodden European Union members such as Spain and Italy. 

Worse still is the mountain of debt refinancing European companies will need. About $4.2 trillion worth of corporate bonds will mature through 2016, according to Standard and Poor’s ratings services. This year alone will see roughly a half trillion come due. But the real tidal wave rolls over the next two years, with $1.03 trillion for 2013 and $1.28 trillion in 2014. If these numbers aren’t scary enough, then consider financial companies owe about 78% of this debt. These companies are the primary sources of liquidity to keep the commercial gears of the EU greased. If investors are hesitant to buy European sovereign debt, then the mere idea of buying European corporate debt — especially for financial companies — would send them running for the hills. 

Then what happens? 
Oh, you know, the usual: confidence continues to deteriorate and credit markets freeze up, causing bank runs, recessions and the social unrest. In short, borrowing rates for these countries and businesses could continue to go up due to the increased financial risk involved in lending them money. This will affect interest rates and financial markets worldwide.

How to defend your portfolio
The  United States won’t be completely immune, but there are a few steps investors can take now to protect themselves.

1. The best offense is a good defense
Dividend-paying stocks of domestic, defensive companies (consumer staples, pharmaceuticals, utilities, etc.) may not move as much on the upside during periods of market volatility. The tradeoff will be less downside volatility, as defensive stocks offer stable income, even in troubled markets. 

A few select names would be Eli Lilly (NYSE: LLY) in the Big Pharma space, with a dividend yield of 4.5%; regulated utility Exelon (NYSE: EXC), which pays a 5.5% dividend; and consumer staple giant Kimberly Clark (NYSE: KMB) which, although it has a strong history of growing its dividend (currently at 3.5%), shares at today’s prices look a little expensive. It’d be best to add this one on a pullback. 

2. What to avoid
Although weakness in European sovereign debt could spell strength in U.S. Treasury bonds, don’t fall for this investment idea. 

The yield on the 10-year Treasury is a paltry 1.6%. Any additional rally in Treasuries due to lack of confidence and the notion that the United States is still an investment safe haven will only send this yield lower. While you may experience some price appreciation, it’s not enough to be paid only half the rate of inflation and basically pay a premium for no compensation and additional risk. 

Further stress on the European system will continue to weaken the euro and strengthen the U.S. dollar. And a weak dollar tends to strengthen commodity prices, while a stronger dollar sends these prices lower. Stocks of materials producers (miners, metals, agriculture, etc.) and related businesses will likely underperform. 

One exception might be energy stocks. I still like some of the pipeline stocks that yield more than 7% such as Boardwalk Pipeline Partners (NYSE: BWP) and Suburban Propane Partners LP (NYSE: SPH). From the big integrated space, I still like ConocoPhillips (NYSE: COP), yielding 4.7%, and Total SA (NYSE: TOT) yielding 5.5%. Yes, I know Total is a European concern, but shares offer a deep value, superior yield and growth exposure to emerging markets. 

Oh and one more thing… I wouldn’t touch financial stocks with my worst enemy’s 10-foot pole. This sector will likely be toxic for a long time. 

3. Cash may not be king, but it carries some clout
Cash is not an investment. These days, and for the next few years it seems, it pays precisely nothing. But it also doesn’t go up or down, which can take some volatility out of your portfolio, while providing a stable alternative to bonds. It also gives you dry powder to add to high-quality stocks to your portfolio at a discount down the road. Going to all cash is a bit too reactionary. But a 10-20% cash position out of your overall portfolio may not be out of the question.

Risks to consider: I could be completely wrong. European countries could get their act together and figure out how to coordinate all fiscal and monetary policy, thereby saving the day. Unfortunately, I’m quite pessimistic about this likelihood. History suggests we have further troubles to come, and I just don’t see these troubled countries subordinating themselves to Germany regardless of the consequences. 

Action to take –> Europe is a bona fide mess and, although the United States is in better shape, our economy is muddling through a mediocre recovery. It behooves smart investors to be a little cautious. Avoiding bonds, or at least putting new money in bonds, is prudent while focusing on high-quality and dividend income from the equity component of your portfolio. The stocks I’ve mentioned above are a good start. Also, my colleague Amy Calistri’s work on dividend income investing in her Daily Paycheck newsletter offers insight that may prove helpful in facing these challenges.