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A Quarterly Publication September 30, 2015

Capital Investment Services of America, Inc.

700 North Water Street, Suite 325 Milwaukee, Wisconsin 53202-4206

414/278-7744 800/345-6462

info@capinv.com www.capinv.com

In This Issue . . .

Where are the economic

superheroes when we need them?

Policy makers are searching for

the keys to prosperity under the

lamp post.

History reveals the keys.

Policy makers cannot create

prosperity.

Their policies can help or hinder

the creation process however.

“Common folk” free to search and

exchange solutions to life’s

problems are key.

Innovationism better descriptor

than capitalism of the creation

process.

U.S. recession still not likely

anytime soon.

Investment climate change

becoming more apparent to all.

Appendix 1: Demographic

tailwind building.

Appendix 2: The busts following

commodity price booms tend to be

long lasting affairs.

Appendix 3: Earnings and P/Es

tend to decline in bear markets.

Ant-Man and the Search for the Lost Keys

Superman, Batman, the Avengers, and most recently, Ant-Man. If

Hollywood movies are any indication, the viewing public is

infatuated with the notion of superheroes. The storyline of heroes

overcoming seemingly insurmountable odds to save the world just

never gets old apparently.

Where-oh-where are the economic superheroes when we need them?

We have often discussed how the post-2008 Financial Panic

economic and investment climate has been marked by what market

observer Scott Grannis has termed FUD—fear, uncertainty and doubt.

In recent months FUD has intensified, stock markets have become

volatile with prices sharply “correcting” and economic confusion

reigns.

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Consider:

Investors have recently heard the Pope warn of the evils of “unfettered capitalism” just as the VW scandal

erupted, and a food executive is sentenced to prison for knowingly selling tainted peanut butter. Meanwhile, an

avowed socialist is drawing crowds and hopes to emerge as a U.S. presidential contender.

Investors are also hearing high-profile and influential economists speak of secular economic stagnation. Many

of these economists have had their confidence shaken as the implementation of their government stimulus

policy prescriptions—based on the ideas of their economic superhero John Maynard Keynes—failed to “create”

the economic growth expected and have instead saddled countries with large government debt loads.

What about the Federal Reserve?

Judging by the incredible attention every Fed member’s utterance receives, and the 24/7 news and noise crowd

screaming that each Fed meetings is the “most important in history!” has some apparently believing the Fed is

the economy’s superhero.

Fed policy is indeed important. In the heat of the 2008 Panic, they did not make the catastrophic mistakes of

their 1930s counterparts. Instead, they rightly fulfilled the lender-of-last-resort role and prevented a Great

Depression rerun.

In recent months, the Fed has been telegraphing the need to soon move away from their crisis zero-interest-rate

policy.

However, in a press conference after the most recent Fed meeting—in which they decided not to raise rates—a

reporter asked Fed Chair Janet Yellen if she was worried that the Fed might be trapped with zero-interest rates

forever. Yellen was less than reassuring: "I can't completely rule it out."

The Fed went on to lay out their own gloomy, secular-stagnation-type U.S. economic forecast. Then in a

speech about a week later, Yellen again talked of the Fed’s need to raise rates soon.

So which is it….zero rates forever? A rate hike as part of an interest-rate-normalization policy? The Fed, too,

seems confused as it searches for the magic policy wand to make things all better.

Not surprisingly, FUD intensified after the Fed’s meeting.

More fundamentally the markets ask: “After all the Fed’s bond buying actions and years of zero-interest-rate

policy, a nearly trillion dollar stimulus plan from the government, massive plans to “fix” healthcare and the

banking system, and all we get is a substandard economic expansion?” And now, with the widely-perceived

growth engine of the world (China and the emerging markets) having economic troubles, certainly another

economic meltdown is dead ahead, right?

Where-oh-where are the economic superheroes when we need them?

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History reveals the keys Implicit in the lament just offered is confusion about the fundamentals underlying the keys to economic

prosperity and growth. Top-down policies crafted in Washington D.C., Tokyo, Brussels or Beijing are not the

answer.

Like the old joke about searching for lost keys under the lamppost because “that’s where the light’s best”, the

keys lie beyond top-down policies.

Central banks and governments cannot create economic growth or wealth. Their policies can certainly help, or

hinder, the growth creation process. But they are only ingredients in the prosperity cookbook.

The real superheroes? As discussed in last quarter’s The Searchers and the Heartbeat, they are the millions and

(now due to globalization) billions of people engaged in the unrelenting search for a better life. Their search

drives innovation that moves the general standard of living forward by coming up with better solutions to the

problems inherent in everyday life.

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Chart 1: The searchers have been busy changing life for the better

Source: AEI Carpe Diem blog

For much of human history, the way to accumulate wealth was mostly through (typically violent) conquest and

confiscation. As nations began to trade with one another this changed some, but the standard of living still

made little progress for centuries.

The situation profoundly changed roughly 200 years ago as “common folk” were given political and economic

freedoms. Unleashed as searchers, wealth accumulation by creating/providing something that was voluntarily

(and peaceably) exchanged with others that improved the lot of both parties involved in the exchange emerged

in a big way. Millions have been lifted out of abject poverty by this dynamic process.

The keys to rising prosperity for humankind were discovered! The keys did not reside in the limited brain

power of a few superhero “masters”, but emerged out of the collective brain of searchers who were allowed to

innovate and trade.

“People flourish in an environment of freedom”

“People flourish in an environment of freedom”.

Edmund Phelps, Nobel Laureate in Economics

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We believe history clearly shows the innovation dynamic works best within a process of market-vetted

experimentation. One of the most underappreciated aspects of market-based economies is the importance of

pleasing others as the ingredient for commercial success. The products and services that most please customers

typically grow and displace those that do not.

The economy, of course, revolves around humans. The Pope is correct, there are indeed the greedy, those full

of hubris, the scoundrels, liars and cheats operating within the marketplace. Human beings are flawed creatures

to be sure. That’s not an excuse for bad and dangerous behavior, but recognition of reality. These same human

flaws may exist within government officials, by the way. At least in the marketplace, “bad actors” are

ultimately subjected to both the rule of law and the “law” of the marketplace (unrelenting competitive pressure).

Innovationism is a more apt descriptor than capitalism One of the problems we see with modern economy as a field of study is the perception that the economy is

some sort of machine. Perhaps suffering from what some have described as “physics envy”, many economists

seem to see themselves as engineers using mathematics as the tool to model and control the “machine”.

But, as the Einstein quote nearby reminds, some economic variables which count a great deal are not prone to

mathematic measurement let alone “control”.

It was recently reported that the aerospace engineers were off by merely one minute in the three billion mile,

nine and one-half year New Horizon space ship journey past Pluto. By contrast, in the messy, human, real

world of economics, “fiscal multipliers” can be zero or even negative contrary to Keynesian economic models.

And, “money velocity” is not always constant as the quantity theory of money and monetarists assume.

The economy-as-machine perspective is also reinforced to some degree by the very word, capitalism. The term

implies a mass of accumulated capital (machines and money) resides at the heartbeat of a market-based

economy. Karl Marx, and more recently, Thomas Piketty, offer ominous theories that accumulated capital

inevitably will lead to economic control by a few.

But the economy is less about accumulated “capital” and much more dynamic than many appreciate. As seen

over time, frequent changes within members of the Forbes 400 “richest” list reflects the underlying dynamism.

De-concentration of wealth over relatively short periods of time seems to better describe reality.

And, as the out-of-the-lime-light economic historian Deirdre McCloskey points out in her Bourgeois Dignity

books;

“Our riches (the great growth in the standard of living that’s occurred in the past

200 years) were made not by piling brick on brick, bank balance on bank balance,

but by piling idea on idea.”

“What counts can’t always be counted; what can be

counted doesn’t always count.”

Albert Einstein

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And this is truer today than ever. Whereas once it took huge sums to commercialize an idea or launch a new

business, today searchers with an idea, borrowing on credit cards, often launch and operate significant business

ventures (see Sidebar below).

According to new statistics released by the U.S. Census Bureau, there were 30,174 “non-employer”

firms that brought in $1 million to $2,499,999 in 2013. That’s up from 29,494 in 2012 and 26,744 in

2011.

And there are many more non-employer businesses getting close to the $1 million mark. What’s driving

their success? One factor is the growth of the internet, which has enabled individual entrepreneurs to

plunge into a vast, global marketplace cheaply and quickly. “It’s provided a whole set of capabilities

and tools these entrepreneurs can access,” says Andrew Karpie, a principal analyst at the Research

Platform in San Francisco.21

We believe McCloskey’s term innovationism is much more descriptive of the dynamics driving economic

advancement than capitalism.

Caged eagle or turtle?

The good news about the economy today is that the super-hero searchers are greater in number and better

empowered by technology to “pile idea upon idea” than any time in history.

We believe McCloskey’s term innovationism is much more descriptive of the dynamics driving economic

advancement than capitalism.

Caged eagle or turtle? The good news about the economy today is that the superhero searchers are greater in number and better

empowered by technology to “pile idea upon idea” than any time in history.

Digitalization of information, affordable cloud computing and “big data” analysis are powering significant

advances in medical knowledge, materials science, enabling “in silico” simulation that both dramatically

reduces the cost of R&D and increases the speed new products hit the market, the revolutionary potential of the

internet of things, 3-D printing, direct digital manufacturing and mass customization of products.

1”The future of Work”, Brendon Schrader, Fast Company.com, September 2015

2“How Bold Entrepreneurs Are Breaking $1 Million In One-Person Businesses,” Elaine Pofeldt, Forbes, May 30, 2015

SIDEBAR

As of May 2015, 15.5 million people in the U.S. labor force were self-employed, according to the Bureau

of Labor Statistics –an increase of roughly one million since May 2014. That number is expected to keep

growing at a steady clip.

By 2020, a separate study estimates that more than 40% of the American workforce, or 60 million people

will be independent workers—freelancers, contractors, and temporary employees.

Increasingly, contractor positions are held by the best and brightest. Harvard Business Review recently

called this phenomenon “The Rise of the Supertemp”.1

An exciting trend is brewing in the U.S. economy: the growth of ultra-lean businesses that are hitting and

exceeding $1 million in revenue at a stage when they have no employees other than the owners.

According to new statistics released by the U.S. Census Bureau, there were 30,174 “non-employer” firms

that brought in $1 million to $2,499,999 in 2013. That’s up from 29,494 in 2012 and 26,744 in 2011.

And there are many more non-employer businesses getting close to the $1 million mark.

What’s driving their success? One factor is the growth of the internet, which has enabled individual

entrepreneurs to plunge into a vast, global marketplace cheaply and quickly. “It’s provided a whole set of

capabilities and tools these entrepreneurs can access,” says Andrew Karpie, a principal analyst at the

Research Platform in San Francisco.2

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Though the productivity benefits of many of emerging innovations are hard to measure by traditional economic

statistics designed to count “things” under the lamp post, their impact we believe will accumulate to become

significant over time.

Still, the slow-growth, substandard economic expansion in the U.S. is more than a mismeasurement issue.

Increased government intervention in the economy, either directly or through increased tax and regulatory

hurdles, have reduced economic freedom, dampened business’ willingness to embark on new investment plans

and slowed growth.

There is also a negative psychological impact on economic participants. In part it is due to diminished “animal

spirits” (to use Keynes’ term)—a toll of pervasive FUD as the memories of 2008 Panic linger. But another

hard-to-measure element is likely at work as well.

On prior occasions, we contrasted the post-2008 Panic economic “psyche” with that of the 1930s. Forceful

government intervention in the economy, by the administration of Hoover and FDR, and real or imagined

assaults against business dampened business spirits.

While the situation today is certainly less pronounced along these lines, an atmosphere of distrust of market

systems and lack of respect for businesses and business people have not fostered an environment conducive to

risk taking and business expansion plans. No doubt some businesses believe money is better spent trying to get

on the favored side of Washington politics.

“They (businesspeople) feel threatened. They realize that they are on trial before judges

who have the verdict in their pocket beforehand, that an increasing part of public

opinion is impervious to their point of view, and that any particular indictment will, if

successfully met, at once will be replaced by another.”

Joseph Schumpeter, Economic historian

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Continued slow growth—as we’ll outline next—remains the likely state of domestic economy. The keys for a

higher standard of living for most everyone still exist and are within reach, however. The domestic economy is

more like a caged eagle than secular-stagnation-turtle.

No U.S. recession likely any time soon Even as the booms associated with the “emerging markets century” and the associated “commodity super-

cycle” morph into credit-laden busts, we believe the U.S. expansion possesses sufficient resilience to avoid

recession anytime soon.

The primary reasons include:

The innovation trends noted earlier will drive productivity growth.

Emerging favorable demographics as millennials become a significant economic force.

Now larger in number than the baby boom, this demographic “cohort” tends to start the

greatest number of new businesses, form more households, and buy the greatest number

of houses, home furnishings and autos. (Appendix 1, page 10, provides more detail).

Lower commodity prices are ultimately a favorable development. However, benefits

are currently being overwhelmed by the intensity of the bust and its impact on energy

companies’ spending (see Appendix 2, page 11).

Consumer debt obligations reside at levels not experienced for decades.

The banking system is also better capitalized than it has been in decades.

Widespread accumulated excesses (typically debt and inflation) that make a business

expansion brittle and prone to recession are generally lacking.

Most every recession in history has been preceded by “tight” liquidity conditions. A

great deal of Fed rate hikes would be required for present domestic financial liquidity to

become contractionary for the economy.

The resilience of the current expansion is, of course, important for investors. Although there are no clear

definitions of stock market price “corrections” and “bear markets”, there are important distinctions.

Corrections tend to be relatively frequent, and since they occur within the context of an ongoing economic

expansion, tend to be relatively short term setbacks.

Bear markets, by contrast, are characterized by much more severe price declines, are longer lasting and highly

associated with recessions (see Appendix 3, page 12).

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The recent FUD escalation has triggered recession worries and a stock price correction. The good news is that

it has also lowered the “expectations bar” for both economic prospects and company sales and earnings results.

Too gloomy expectations are the ingredients for relief as reality delivers better-than-expected results.

Investment trend transition underway; out with the “old”, but what’s the “new”? FUD has also been stoked by investor confusion. We have been discussing the unfolding climate change within

the investment environment for some time now. The “old” trends—the emerging markets century and the

associated commodity super-cycle— have failed to re-exert themselves.

And it probably will be quite awhile yet before they do. Many countries and companies that were beneficiaries

of the boom times are now saddled with debt problems that may require an extended period to work through.

Appendix 2 (referenced earlier) also shows that the history of commodity price busts after the type of boom the

world has experienced are protracted affairs.

Invoking the looking-under-the-lamppost metaphor one last time, much Wall Street infrastructure remains

geared up to position investors for the old trends. Wide asset allocation portfolios with a heap of exposure to

nearly everything, including emerging market bonds, stocks and commodities, are the overwhelming rule.

Investment dollars usually flow to where they are treated best; so much of this money is likely becoming

anxious and restless. But what are the new trends?

While the old investment trends were largely big-picture, macro-economic oriented, we believe the new trends

are proving more company-specific “micro-economic” in nature.

Companies with searcher mentalities and capabilities are finding a way to grow despite the slow growth macro

backdrop. As a result, they have the best probability to generate the sales and earnings growth coveted and

rewarded by investors.

It’s well known that ants have superhero strength relative to their size. The superheroes driving innovationism

are the everyday folks busy searching for, and delivering, solutions to problems. For investors, a portfolio of

searchers is likely the way to maximize the probability of investment success.

“Wagering against human ingenuity has always

been a bad bet.”

Vivek Wadhwa, Stanford technologist

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Appendix 1: Demographics; now a tailwind?

The “new generation” is no doubt different than predecessors in many ways, but when people marry and have

kids, they tend to form households and spend accordingly.

Chart 2: This age group creates lots of new businesses, buys lots of car, homes and home furnishings

Source: Morgan Housel

Chart 3: Household formation on the rise…

Chart 4: Housing market comeback ahead

Source: ISI

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Appendix 2: The history of commodity price boom and bust cycles

Commodity prices have historically exhibited dramatic boom and bust cycles. Busts have been long lasting

affairs as the following table and accompanying chart (on the following page) reflect.

The table creates a view of the history of busts and scales at the “0” point. If the current bust “rhymes” with

past bust phases, the bust phase still has many years ahead.

The table also indicates another important point about busts—the initial years tend to be most violent. This bust

cycle appears to be fitting the historical pattern so far.

The effect on the economy, thus far, has been mostly negative as the spending adjustments by the domestic

energy industry in response to lower energy prices have been significant. Still, we believe lower commodity

prices will accrue and prove to be a net benefit to the economy.

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Appendix 3: Stock bear markets typically occur in recessions

P=P/E x E

Where:

P=stock prices

E=corporate earnings

P/E= price/earnings ratios=a common stock valuation metric

Stock price “corrections” tend to trigger a reduction in stock valuations (P/E’s) but prices recover as

corporate earnings (E) still grow with the economic expansion.

In bear markets both “P/Es” and “E” are pressured lower as economic recession takes a toll.

As the chart below reflects, corrections often occur around the Fed’s initial interest rate hike in a business

expansion.

Recessions often bring stock bear markets.

Established in 1981, Capital Investment Services of America, Inc. is a Milwaukee, WI based independent investment

counsel providing custom tailored portfolio management to individuals, businesses, and charitable institutions.

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The information contained in this report is based on sources believed to be reliable, but we do not guarantee its accuracy or completeness. The information is published

for informational purposes and does not constitute an offer, solicitation, or recommendation of an investment or advisory services.