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A Quarterly Publication June 30, 2013

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 . . .

Economic expansion is still

young at heart

An industrial renaissance and

an energy revolution are also

underway

Slow but long business

expansions the new norm?

Economic clock has not been

rewound to 1937 either

Stock market resuming leading

indicator role?

Not so sanguine about bonds,

however

Emerging markets undergoing

structural change

Telling the Time

What “time” is it in the economy? At four years and counting, is the

current economic expansion long in the tooth? After all, this

economic advance is about as long in duration as the average

expansion in the post-war period.

Alternatively, is the economic clock being rewound even further

back, all the way to 1937? Back then, the Federal Reserve thought

the Great Depression was behind them, and so they shifted their

monetary policy stance and unleashed the granddaddy of double-dip

recessions. Is the current Fed taking us down the 1937 path?

What time is it in the stock market? After achieving all-time new

“highs” in many U.S. market stock indexes in recent weeks, is the

clock about to run out on the advance?

What time is it with respect to interest rates and bond yields? Is the

30-year bull market in bonds out of time?

Is the clock striking midnight for China, turning their economy into a

proverbial pumpkin and potentially dragging the world economy

down along with it? What time is it in emerging markets in general

and the global economy?

There are no actual clocks to guide investors, of course. However, we

believe a few insights into prevailing conditions, along with some

historical perspective, provide the next best thing towards telling the

time on these and related investment issues.

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Fed Chairman Bernanke speaks…and the markets freak

Economic expansion is still young at heart

Those who have subscribed to our email updates recently received a commentary regarding the state of the

housing and vehicle segments of the economy. (You can subscribe, by the way, at capinv.com, and while you

are there, we invite you to explore our redesigned website). As explained within that commentary, the early

stages of economic expansion are usually powered by vigorous recoveries in auto and home sales.

For most of the current business expansion, however, housing and autos have been a drag on the economy.

Only in recent months have these two sectors begun to contribute to growth. While auto and home sales have

rebounded well off their recession “bottoms”, they still remain below levels consistent with general population

growth and replacement requirements. (The average age of the existing auto fleet is 11 years old, for example.)

Besides giving the economy a cyclical (and temporary) bounce in its step, autos and housing sales also stand to

benefit from emerging demographic tailwinds. As noted last quarter, the 30-44 year old demographic group is

once again growing in numbers within the U.S. This is the first such growth in this age “cohort” since the year

2000.

This demographic group is of particular focus for they have typically been responsible for “moving the needle”

with respect to household formation and all that comes with it—auto purchases, home sales and furnishing

expenditures. Just as importantly, this age group also has been responsible for the bulk of new business

formations and associated job growth over time. We expect they will again prove to be significant contributors

to economic growth over the next several years.

While some pundits worry that recent (and potential future) increases in mortgage rates threaten housing

prospects, most assessments of housing affordability suggest mortgage rates would have to go a good bit higher

before the housing recovery would be impacted (Chart 1).

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Chart 1: Housing affordability has a cushion against rising mortgage rates

(Source: ISI Group)

An industrial renaissance and an energy revolution are also underway Housing and auto fundamentals are not the only reasons the expansion is young at heart. The relentless push for

productivity growth by businesses continues to be intense. To compete successfully, firms are on the hunt for

tools, methods, and technologies that enable them to produce products and deliver services more cheaply, more

quickly, and with higher quality.

Simulation software, computational manufacturing, 3-D printing, voice recognition software, and advanced

robotics are just some of the technologies that are powering a renaissance in U.S.-based industrial activity. This

renaissance is also gathering momentum from the dramatic shift in the domestic energy situation that is

unfolding—despite political odds—as a result of hydraulic fracking and horizontal drilling technologies. (See

Charts 2 and 3.)

Chart 2: The revolution is for real

Mortgage rates would have to rise above 6%

to just bring housing affordability back

down to its long-term median level

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The supply and cost implications of the energy revolution benefits U.S. consumers to be sure, but also provides

significant competitive advantages to U.S. domiciled manufactures (Chart 3).

Chart 3: Significant cost advantages exist

Price of Natural Gas ($ per British Thermal Unit)

(Source: Strategas)

The productivity gains and energy situations also are beginning to reverse some long established trends.

Whereas “offshoring” and “outsourcing” activities to foreign destinations were all the rage in past years,

“reshoring” and “insourcing” are emerging and bringing industrial activity and jobs to the U.S. from overseas.

The Wall Street Journal recently documented these trends within the auto industry. The story noted:

Honda Motor Co., once a big importer of Japanese-made cars, says it expects to export more

vehicles from North America—with nearly all of them coming from its U.S. factories—than it

brings in from Japan by the end of 2014.1

Research firm Cornerstone Macro added some details on this development:

Since December of 2008, U.S. domestic vehicle sales (i.e., vehicles assembled in North America)

have increased 56%, while sales of imported vehicles have increased just 24%. Why? Cheap

energy, low transport costs, and superior productivity are all long-term supports.

We suspect investors will hear a great deal more about these emerging trends over the next few years as they

continue to power and reshape the domestic economy.

1 A Revitalized Car Industry Cranks Up U.S. Exports, Wall Street Journal, July 2, 2013

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Slow but long business expansions the new norm?

That the pace of the current expansion has been slow is well documented. But, there is a silver lining in the

grind forward nature of the advance. Slow also likely means long in terms of the duration of the

expansion. This is not without precedence.

The last two business cycles (those of the 1990s and the 2000s) were also both punctuated by “sub-par” growth

for the first three years. These two expansions also ended up running much longer (at roughly 9 years and 7

years, respectively) than the 4-year post-war norm.

Why might a tradeoff exist between the speed of an economic expansion and its duration? With “slowness” in

growth also comes slowness in the build-up of businesses cycle excesses—particularly in the form of debt

accumulation and inflationary pressures. Traditionally, as these excesses build, the vulnerability of the

economic expansion significantly increases.

In the past, we used the analogy of the form-fitting material spandex to describe business cycle dynamics. If a

once sculpted athlete gains weight, the spandex shorts that had highlighted his or her physique can stretch to

accommodate for a time. Additional stretch may be possible with still more weight gain, but the risk increases

that a rip in the fabric will occur.

In 2008 we had a major rip in the stretched financial fabric. In the midst of the current economic expansion, the

memories of 2008 have remained vivid. Fear, uncertainty, and doubt have been pervasive. Caution, not

boldness nor recklessness, has been the constant companion of businesses and consumers.

Massive cash hoards exist at many companies, bank and consumer balance sheets are also generally in good

shape (see Chart 4). Troubling excesses in debt are absent.

Chart 4: Consumer balance sheets are absent of end-of-cycle vulnerabilities

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Excesses on the inflation front also appear lacking. Those forecasting troublesome inflation as a result of Fed

policies believe it is only a matter of time. We are not in that camp.

To see why, it may be helpful to consider a profound distinction made some years back by economist Ed

Hyman. He noted the importance of differentiating between Fed actions that build a mountain of money, and

Fed actions that “fill a hole” within a ripped financial fabric.

The 1960s and 1970s serve as a prime example of the inflation that accompanies a Fed-created money

mountain. In contrast, we believe Fed actions of the past few years are of the “filling-the-hole” mode. During

the 2008 Financial Panic, much of the so-called “shadow banking system” (non-banks that extended credit)

retreated or disappeared outright. Within the banking system, stressed balance sheets no longer could support

prior lending commitments—let alone extend new credit. The Fed stepped in as “lender of last resort” to fill

the hole created within the financial system.

Chart 5 portrays some of the “hole-filling” activities of the Fed. Their actions eased the impact of the ripped

financial fabric and prevented a Great Depression repeat.

Chart 5:

The Fed has stepped in to fill a hole created

as financial firms retreated and retrenched

Change in Consumer Debt Outstanding + Change in Federal Reserve Balance Sheet

(vertical axis = % change, horizontal axis = year)

(Source: Cornerstone Macro)

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Relatively recent memories of the 1970s provide cause for concern about inflation. However, the inflation

clock has not been rewound to that earlier period. Very different economic circumstances prevail, currently

making the inflation outlook more benign than many pundits fear.

Economic clock has not been rewound to 1937 either In recent days, the Fed has begun laying the groundwork for “tapering” its hole-filling actions. Some worry if

the economy can withstand such a change in Fed policy. These worries largely stem from the experiences from

another instance (1937) when the Fed ended major hole-filing actions.

As we noted a few years back, the Great Depression economy was punctuated by two bookend recessions: the

massive economic contraction that accompanied the collapse of the financial system in 1930-33 period and the

savage double-dip downturn of 1937-38.

The Fed in 2008 boldly avoided repeating the disastrous monetary mistakes of 1930-33. The modern day Fed

rushed in as “lender of last resort” while their counterparts failed to do in the early 1930s.

Similarly, it is important to distinguish between the indicated policy of the current Fed and that of the 1937 Fed.

The 1930s Fed crushed the recovery that had unfolded between 1934 and 1936 by literally jumping on the

monetary brakes. The current Fed in contrast, is suggesting a gradual “tapering” of their hole-filling actions.

Chart 6 reflects Fed actions through the lens of changes in the supply of money. Sharp contractions in the

money supply that contributed to the 1930s bookend economic contractions are easily visible. One does not

need to strain their eyes to see that current policy looks much different from that of the 1930s.

Chart 6:

Contraction in money growth (M2) shows the mistakes of the 1930s Fed.

No 1930s rewind going on now.

-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 not like the 1930's

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Will Fed policy become “tight” again at some point in the current economic expansion? Absolutely. As

excesses build—including some rise in inflationary pressures as the expansion reaches “old age”—tight policy

to combat the excesses will sow the seeds of the next recession. But until excesses build, those days are likely

some time off into the future.

Stock market resuming leading indicator role? Just like Fed policy, we believe the stock market is in the midst of an important transition as well. Typically the

stock market is a leading indicator of the economy and the prospects for corporate earnings. In recent years it

strikes us that the stock market has behaved more like a lagging indicator. New all-time “highs” in stock prices

merely reflect the fact that corporate earnings have been making record new highs for the past three years.

This year’s stock price advance seems reflective of an increased confidence in the resiliency of the economic

expansion. The increased confidence appears a long way away, however, from the type of optimism and

euphoria that characterizes market “tops”. The nearby “market clock” diagram provides a generalized anatomy

of bull markets and changes in investor psychology.

Bull Market Psychology Clock

(Based on legendary investor John Templeton’s observations)

With signs of market-top type froth in stock valuations largely absent, with major investors (pension funds)

having their lowest exposure to stocks traded on U.S. exchanges in decades, and few believing investor

sentiment could ever again even reach the optimism/euphoria zones, it would appear the current bull market is

still in the early “rise on skepticism” stage.

This is not to say that the advance will be a straight line up, of course. The skepticism phase is, by definition,

marked by fragility in confidence. And the world is (as always) anything but trouble free. Recurrent bouts of

jitters are ahead, but we expect the bull market, like the economic expansion itself, will prove resilient.

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Not so sanguine about bonds, however

Despite market noise to the contrary, we believe the Fed’s talk about moving away from its hole-filling actions

is a favorable signal for investors. Rising interest rates and bond yields are reflective of increased confidence

that the Fed’s hole-filling actions are no longer necessary.

The Fed marking a path towards allowing rates and yields to normalize at higher levels will not be an easy ride

for bond investments. Especially if the yield rise is compressed in a short period of time, as the last several

weeks have suggested might be the case.

How high might bond yields lift in the “normalization” process? Using the 10-year Treasury as a gauge, 4-5%

yields (it currently is approximately 2.6%) likely represents “normal” yield structure given prospective

economic growth rates.

As the normalization process unfolds, we expect the risk/reward profile of bonds will materially improve, and

as it does, we anticipate becoming bond buyers once again.

Emerging markets undergoing structural change

We believe the emerging markets investment story entered a new and much less favorable “time zone” over the

past few years. Because many developing countries roughly peg their currencies to the U.S. dollar, they have,

in essence, imported the monetary policy of the U.S. And while the Fed’s hole-filling monetary policy was

appropriate for the U.S. as we discussed earlier, in emerging markets cases inflationary “money-mountain”

situations have evolved.

In addition, three other problems have emerged in the developing world. Their labor cost advantages are

rapidly eroding as wages have risen substantially faster than productivity growth (crushing the profit margins of

home-grown companies), they are experiencing mounting credit problems from their money mountain

situations, and they have limited policy options to deal with these troubles.

The communist leadership in China, for example, is trying to slow growth to deal with these issues. However,

the difficulty of combating accumulated excesses is compounded by the pressures from a populous that is eager

to climb the economic ladder out of poverty. Additionally, China must grow fast and soon, for the average age

of its population is rapidly increasing as a result of its “one child policy” of previous decades.

While China’s slowdown may periodically be a source of “jitters” in world markets in the months to come, the

good news for developed countries is the downward pressure on their inflation rates as commodity prices

decline. The story behind escalating prices of many commodity prices over the past decade has been the rapid

build-out of China and other emerging market economies. Slower growth is making the commodity “super-

cycle” that supposedly was here to stay look much less “super”. And that is good for consumers and many

businesses around the globe.

In closing, the “time clocks” on many trends appear to us to be giving off favorable readings on many fronts.

Although the global economy looks to be downshifting to a lower growth gear, the U.S. looks to be shifting to a

higher growth gear as the technology revolution and the renaissances in manufacturing and energy evolve, the

U.S. stock market advance still has ample room to run, higher bond yields reflect greater confidence, and

inflation and debt excesses in the U.S. are not likely to reach the troublesome stage for some time.

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The perennial refrain from critics is: You just don’t get

it. Internet stocks / housing / energy prices / financial

stocks / gold / silver / bonds / high-yield stocks /

emerging market stocks and bonds/you-name-it can’t

go down. This time is different, and here’s why.

But this time is never different. History always rhymes.

Human nature never changes.

Jason Zweig

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2Saving Investors From Themselves, The Intelligent Investor, Wall Street Journal blog,

6/28/13

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

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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

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