Investors do not react well to surprises. Surprise events in economics, geopolitics, as well as company earnings’ are accompanied with volatility in the markets.

We are currently in one of those times when surprises abound. The Volatility Index “VIX” recently reached extreme highs signaling great uncertainty in the markets. The stock market’s major declines, gold’s parabolic rise and low U.S. Treasury yields all point to uncertainty.

Why All the Uncertainty?
To restate the obvious, something happened that we were not expecting.
Economists had predicted that the economy would grow at a slow but sure rate of 2%-3% for the next few years. They expected the world economies to follow suit (in general). The markets accepted this level of growth at this point in the economic recovery that started in late 2009.

Then the storms came. The European debt crisis persisted and extended into the larger economies, The U.S. economy showed a significant slowdown and Congress killed any remaining confidence with their “Debt Ceiling Showdown.” All of these events were surprises to the prevailing market views and collectively, they cracked the fragile shell of the market confidence.

What had been a mid-cycle slowdown now became a potential double dip recession in the minds of investors. Economists were not prepared, stock analysts were not prepared and traders were not prepared. Consequently, the market did what it always does. The market filtered all the available data and adjusted to the current environment.

History is littered with events like this, and more times than not, the market overreacts to the new expectations. This could be one of those times. The economy is clearly slowing but is it recessing? Should the stock market be trading 20% lower than it was a few months ago? We will find out very soon.

As Paul Harvey said, “Now the rest of the story.”

What we have described above is a cycle. Just like the changing tides are cycles that rejuvenate and cleanse, the market’s ebbs and flows is a cycle where variations in economic activity both domestic and global are filtered and factored into the daily prices of individual companies and therefore indices.

As investors, we must step back and do several things:

• First, what is the purpose of our investment portfolio? What is our game plan? What do I need from my portfolio- growth for the long term, income for lifestyle needs or a combination?
• Second, we must understand the market cycle and how it affects our game plan. How much volatility or downside can we withstand?

As your manager, we understand that this is part of a cycle. Here are a few things of the steps we have taken recently.

Upgrading Our Portfolios: We have reviewed our companies and are selling those that have been on our watch list or are underperforming. We are buying the companies that have performed well but the price has declined due to the market correction. This has allowed us to move into better quality companies at lower prices than a month ago.

Making Modest Sector Adjustments: We have made modest adjustments to market sector allocation in anticipation of a slower than expected economic activity for the next several years. We are increasing our allocation to defensive sectors like consumer staples, utilities and health care.

Raising a Bit of Cash: Our cash levels have moved up a bit: We have sold some companies and plan to retain extra cash to take advantage of future opportunities and to be more defensive.

Analyzing Fixed Income Alternatives in a Low Rate Environment: The Federal Reserve has told us that interest rates will be low for awhile; consequently, we are looking for bonds that will give us more yield through this time period without extending the maturities significantly.

All of these adjustments are modest and are designed to take advantage of the current situation. Your long-term game plan is the overriding guidepost. There will always be surprises in the market. Our portfolio management process is designed to build a long term portfolio that will weather the storms.