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A Quarterly Publication March 31, 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 . . .

“We will be moving from an ultra-

expansionary monetary policy to

an extremely-expansionary

monetary policy”.

Crosscurrents galore.

Many of the crosscurrents reflect

major changes in prevailing

investment trends.

Old trends: commodity super-

cycle and emerging markets

century are giving way to new

ones.

Incipient trends are U.S. centric.

U.S. economy remains one of

most dynamic in world.

U.S. demographics are a tailwind

that is gathering momentum.

Severe winter weather and West

Coast port strikes have distorted

recent economic indicators.

1937 we take a look back.

Current Fed has learned from the

colossal errors of their 1930s

counterparts.

The Great Depression-variety of

deflation is a very low probability

risk.

From Ultra to Extremely?

Down, up, down.

That has been the monthly pattern for U.S. stock market averages and

bond yields so far this year. The choppy pattern simply mirrors the

many crosscurrents that have emerged to confront investors.

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Among the crosscurrents:

The Yellen-led Federal Reserve (Fed) signaled intentions to raise interest rates for the first

time in nearly a decade.

Some fret that such change in policy risks repeating Fed errors of 1937. Back then the

Fed tightened policy and both the economy and stock market suffered their second violent

downturns of the Great Depression era.

Continued general weakness in commodity prices seems to reinforce the worry for some

that deflation indeed remains a material investment/economic risk.

Meanwhile, economic indicators suggest domestic growth slowed substantially in the past

quarter. Weaker data helped erode already-fragile confidence among many economists

and analysts about the path of the economy.

Despite the apparent economic weakness, McDonalds, Walmart, T.J. Maxx, Target and

others announced pay raises for staff. (See wage cartoon on next page).

In contrast to the apparent policy direction implied by the Fed’s intentions, their European

Central Bank (ECB) counterparts went the ‘other way’ and eased by implementing an

aggressive bond buying program designed to boost Eurozone economies.

Greece again emerged as a potential threat to destabilize the Euro.

The exchange value of the dollar surged. Analysts worry foreign currency translations

will reduce 1st quarter corporate earnings releases due out soon. Earnings reports were

already widely expected to be weak because of lower oil company earnings.

Unrest within the Middle East intensified as terrorists provoked actions from and within

Egypt, Saudi Arabia, Yemen and Iraq.

A “deal” with Iran on nuclear enrichment either increases or decreases their capabilities

depending upon which assessments one reads.

Addressing the crosscurrents

What’s likely to happen with geopolitical events? We wish a good fortune teller was available. One can be

pretty certain, however, that they will continue to cause investment angst and periodically roil the markets.

Given their unpredictable nature, investors can cope through appropriate bond/stock allocations and by

remaining vigilant.

When it comes to the prevailing economic crosscurrents highlighted earlier, we believe we have much more

perspective to offer.

Trend change transition

Many of the economic crosscurrents are symptomatic of the unfolding major changes in investment trends

which we have been discussing for some time now.

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The primary investment trends

of recent years had been aptly

summarized by the phrases

commodity super-cycle and the

emerging markets century.

However, with China now

wrestling with massive debt

accumulation and a major

infrastructure overbuild, things

have changed. Its slower, less

commodity-intensive growth has

taken much of the wind from the

sails of the super-cycle and

emerging market investment

trends.

China’s slowdown is not occurring in a vacuum. Slower growth and/or recessions have set in at other countries

that had been beneficiaries of surging commodity prices (Brazil, Russia and even Australia and Canada).

Commodity price weakness has, in some instances, revealed structural economic issues within many countries

that will not likely be quickly remedied.

As hard as it is for some to believe, the investment growth baton has shifted in favor of the U.S. and U.S.-

traded stocks (see Chart 1 below).

Chart 1: Earnings growth in U.S. (S&P 500 EPS) exceeding growth in emerging markets (EM)

Source: Cornerstone Macro

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The catalysts for the trend changes include:

The U.S. economy has dealt with many of the issues that helped set the stage for the 2008 Financial

Panic. The banking system is now better capitalized than it has been in decades, consumer debt burdens

are generally modest, the savings rate is higher than it has been in generations and companies are

generating abundant amounts of cash.

In addition, innovation and the technology revolution continue to be at the forefront of U.S. economic

dynamism. Such dynamism is lacking in most countries around the globe. The innovation trends are

most visible perhaps in medicine (biotech and life sciences), and manufacturing, where a renaissance of

sorts is underway as that sector continues to grow faster than the economy at large.

Innovation bodes well for productivity growth as an important growth driver. The Internet of Things, 3-

D printing, direct digital manufacturing, software simulation, cloud computing and advances in material

sciences all hold promise for new and significant productivity tools.

U.S. demographics remain more favorable for growth than much of the rest of the world (see Chart 2).

Chart 2: Favorable demographics for the U.S.

Source: Morgan Housel

Like productivity growth, demographics can have an important influence on economic growth. In Japan and the

Euro Zone, despite troubling tax and regulatory burdens (Washington D.C. take note), unfavorable

demographics are also playing significant roles. Easy monetary policy alone cannot overcome such headwinds.

(250,000)

(200,000)

(150,000)

(100,000)

(50,000)

-

50,000

100,000

Ch

an

ge

in T

hou

san

ds

Projected Change In Working-Age

Population 2012-2050

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The U.S. demographic tailwind is slowly building momentum. The group born after 1980 now exceeds the

baby boom in number, and their economic impact is likely to be significant. This demographic age group tends

to create the greatest number of new businesses, and purchase the greatest number of autos, homes and home

furnishings.

Chart 3: New highs!

Spending requires income of course, and the good news is employment within this group is now at all-time

highs (see Chart 3 above).

And despite what some of the daily headlines might suggest, good paying jobs are being created (see Chart 4 on

following page).

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Chart 4: It’s likely better than many believe

Commentary and Data from Evercore/ ISI

Meanwhile, a stronger dollar is likely

to remain a byproduct of the shift in

trends we perceive. As reflected in

the table to the left, dollar strength

certainly did not derail economic

growth or halt stock bull markets in

the past. We don’t expect it to in the

current situation either.

The incipient trends have not yet

reached full blossom, nor are they

widely accepted at this point. From

an investor’s perspective this is good news, for the trends are far from being fully exploited in terms of

investment potential.

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Until the trends become more vigorous and obvious, investor confidence will mostly float with the ebb and flow

of economic data releases. Economic releases so far this year have not been confidence-inspiring.

Distorted 1st quarter economic data

The impact last year of severe winter weather on economic data was significant with 2014s 1st quarter real GDP

reported in decline. The weather-induced dip proved transitory, but many found it difficult at the time to

separate an economic signal from the noise of weather.

A repeat of sorts is likely underway in 2015. Regarding this year’s first quarter, economist Brian Wesbury

provides some important context:

“Retail sales were weak, except for buying over the internet and by mail-order. Utilities

soared at the fastest pace in more than 40 years, while manufacturing production fell.

And now housing starts plummeted at the second fastest pace in the last twenty years.

If it wasn’t obvious already, it should be now: the coldest February temperatures for

the most people since 1979 had a huge (but temporary) effect on the economy. In fact,

Americans in 23 states experienced a “top-10-coldest February” going all the way back

to 1895.”

The economic tea leaves were also likely impacted unfavorably by the West Coast port strikes in January and

February. Wesbury also provides meaningful insight on the impact of the strikes:

“The total number of inbound and outbound containers was down 10.2% from a year

ago at the Port of Los Angeles and down 20.1% at the Port of Long Beach.”

With spring weather now upon the country and with resolution of the port strikes, these factors should no longer

be playing havoc with commerce (and economic data).

We do not believe the weak economic readings so far this year are signaling an end to the economic expansion.

Nor are they indicative of conditions that will prove a lasting threat to corporate earnings growth for many

companies.

1937 Fed jumped on the brakes

To assess whether a Fed interest rate hike runs the risk of unleashing a 1937-like downturn, let’s take a trip back

to the 1930s for a few moments. The Great Depression was marked by two significant contractions in the

economy. These downturns were triggered by two sharp contractions in the money supply as Chart 5 on the

following page indicates.

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-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Money Aggregate M2

Annual Rate of Changesources: Historical Statistics of the U.S., Haver Analytics, FT Advisors, Fed. Reserve of St. Louis

1930-33

1937-38

current monetary backdrop nothing like the 1930's

Chart 5: 1930s like contractions in money and the economy not ahead

Economic activity collapsed during 1930-33 as the banking system imploded and the money supply registered

the largest contraction in U.S. history. Ben Bernanke made sure the Fed did not repeat that mistake during the

Financial Panic of 2008 and its aftermath.

The money contraction of 1937 was not nearly as severe as the 1930-33 episode (thankfully!), but it still is one

of the sharpest declines presided over by the Federal Reserve. Like the contraction disaster earlier in the

decade, it, too, was the result of significant monetary policy mistakes.

The 1937 monetary contraction and accompanying nasty recession were preceded by tax hikes and two methods

of policy tightening by the Fed—rate hikes and substantial increases in reserve requirements imposed upon the

banking system.

The reserve requirement policy “tool” reflected new powers granted to the Fed and their inexperience with its

use created trouble. When the Fed became worried about the economy’s inflationary potential following the

vigorous economic rebound of 1934-36, the degree of tightening they undertook using the reserve requirement

tool was likely not well understood.

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One study of the Fed’s actions at the times summarized it as follows1:

“On the basis of well-intentioned ignorance, the first increase in reserve requirements could

be forgiven.

The second round of increases in March and May 1937, however, turned what had been an

ongoing recovery into another cyclical disaster. “Inflationary” potential came down to –20.5

percent, and all the leading indicators of business activity turned negative. By September the

recession was unmistakable.

No inflation of any size could have occurred between 1937 and 1941. What did appear as a

result of Fed-Treasury policies was a sharp recession that further undermined confidence in

the market system.”

In summary: the Fed of 1937 jumped on the monetary brakes and economic activity collapsed. Unlike back

then, we don’t have tax hikes on the table and the Fed won’t be doing any brake jumping.

As current Fed Vice-Chair Stanley Fischer put it (and the source of the title for this Perspective by the way):

“We will be moving from an ultra-expansionary monetary policy to an extremely-

expansionary monetary policy.”

Unlike his 1930s counterparts, Fischer is anything but an inexperienced central banker. He earned accolades for

his years of monetary stewardship as Governor of the Central Bank of Israel and is mentor to current and former

central bankers Yellen, Bernanke and the ECB’s Mario Draghi.

With inflation a non-issue today, why should the Fed even risk any hikes?

The current zero-interest-rate policy was in response to an economy in crisis. Yes, the economy is far from

robust. But the economy is no longer in crisis.

The factors holding the economy back—excessive regulation and taxation—cannot be solved by ultra-

expansionary money policy. Incremental policy moves now may prevent the risk of brake jumping later on.

Unintended consequences and the potential for a monetary policy misstep exist. The dramatic increase in the

size of its balance sheet as a result of its ultra- stance puts the Fed in unchartered waters. But the risk of a 1937

repeat is a low-probability scenario.

Stock market pullbacks and the rate hikes

Last quarter we reproduced the chart on the following page which displays yearly returns for the S&P 500 Stock

Index.

The chart helps make two important points. First, stock “bear markets” (periods of prolonged, gut wrenching

negative stock returns) typically are triggered by corporate earnings stressed by economic recession (shaded bar

areas in chart).

1 The Reserve Requirement Debacle of 1935–1938, Richard Timberlake, The Independent Institute, June, 1999

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Secondly, stock returns often—though not always—also struggle in years in which the Fed tightens policy.

What, if anything, do these historical patterns portend for the current environment?

The present slow-growth economy is marked by few of the growth-threatening excesses that precede recession.

As a result, the next recession (and bear market--hopefully) is likely some years away yet. Economists at

Evercore/ISI suggest the next recession could be five or more years away. Their guideposts follow:

Evercore/ISI Guideposts:

o Recessions typically start roughly five years after the Fed starts to tighten. (Does Fed move

from ultra to extremely qualify as “tightening”?)

o Recessions typically start roughly five years after wages start to accelerate. (Wages starting to

accelerate in 2015?)

o Recessions typically start roughly seven years after housing starts move well over 1 million.

(Housing starts may reach the 1 million threshold this year or next)

Whether or not the stock market suffers a pullback this time as the Fed exits crisis policy mode remains to be

seen. However, if it does, history suggests the pullback won’t be fun but will be relatively short lived and

investors will be well compensated soon after.

Deflation—how real a threat?

Before we put this Perspective to bed, we are compelled to briefly return to the deflation topic. As one

economist stated recently, “Deflation remains the looming zombie apocalypse of international monetary

commentary”2.

2 The Grumpy Economist blog, John Cochrane, University of Chicago, March 20, 2015

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It strikes us that the fears of deflation and its risk to the U.S. economy are largely overblown. Talk of a

“deflationary undertow”, a “deflationary mindset spreading among consumers” and “debt deflation” is common

today. The cartoon below likely captures the typical view of the impact of deflation on an economy.

What is deflation, anyhow? Former Philadelphia Fed President Charles Plosser noted in a 2003 study of its

history3, that deflation is a sustained decline in the general level of prices. Individual prices can and often do

vary, but sustained declines in prices across and economy are relatively uncommon events.

Plosser concludes:

“The claims that deflation is a recipe for economic catastrophe are not well supported by the

historical record or recent experience. Much of the case for such doom and gloom rests on

one episode, the Great Depression. Other episodes of modest deflation, less than 2% (per

annum) seem consistent with continued economic growth.”

Plosser’s conclusions are supported by a more recent study of deflationary episodes across history and

countries.4

The most salient points of the latter study:

“Concerns about deflation - falling prices of goods and services - have loomed large in recent policy

discussions. The debate is shaped by the deep-seated view that deflation, regardless of context, is an economic

pathology that stands in the way of any

sustainable and strong expansion.

(Yet) in the postwar era, in which transitory

deflations dominate, the (economic) growth rate

has actually been higher during deflation years,

at 3.2% versus 2.7%.

The almost reflexive association of deflation with

economic weakness is easily explained. It is

rooted in the view that deflation signals an

aggregate demand shortfall, which

simultaneously pushes down prices, incomes and

output. But deflation may also result from

increased supply. Examples include

improvements in productivity, greater

competition in the goods market, or cheaper and

more abundant inputs, such as labor or intermediate goods like oil. Supply-driven deflations depress prices

while raising incomes and output.”

3 Deflating Deflationary Fears, Charles Plosser, University of Rochester, November 2003

4 The Costs of Deflations: a Historical Perspective, Claudio Borio, Magdalena Erdem, Andrew Filardo and

Boris Hofmann, Bank for International Settlements, March 2015

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In other words, most of the time deflation has been a good thing. When it is the result of innovation that

increases the availability of goods or services to more people, it can stimulate growth. If we are right about

technology and manufacturing delivering innovative new tools that enhance productivity growth, deflation in

the present context is to be cheered, not feared.

The ruinous deflation is that which was experienced and nearly exclusively confined to the 1930s. But that

deflation was the direct result of colossal monetary mistakes by the Federal Reserve. A repeat of such mistakes

under an ultra to extremely Fed policy transition—as we noted earlier—is a low probability event.

The economic expansion and the stock market bull very likely have more room to run.

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.