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Ant-Man and the Search for the Lost Keys

Third Quarter 2015

Download PDFCapital Investment Services Third Quarter 2015 Perspective - Ant-Man and the Search for the Lost Keys

Cartoon: Searching for lost investment 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.


  • 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?

History reveals the keys

Cartoon: Will China's economic cliff-dive take the U.S. economy with?

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.

Chart 1: The searchers have been busy changing life for the better
Spending on food, clothing, cars, household furnishings as share of disposable personal income 1947-2014

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.

—Edmund Phelps, Nobel Laureate in Economics

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 economics 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 reminds, some economic variables which count a great deal are not prone to mathematic measurement let alone “control”.

What counts can’t always be counted; what can be counted doesn’t always count.

—Albert Einstein

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.

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).

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

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.

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.

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.

They (1930’s 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

Cartoon: U.S. Government is the whale swimming with schools of fish labeled special interest groups, crony capitalists, and lobbyists

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.

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 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)
  • 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).

Wagering against human ingenuity has always been a bad bet.

—Vivek Wadhwa, Stanford technologist

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.

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
U.S. population demographics ages 30-44 1990-2025 (projected)
Chart 3: Household formation on the rise…
Percentage of births to U.S. millenials 1992-2025 (projected)
Chart 4: Housing market comeback ahead
New and existing homes for sale as a percentage of U.S. working age population 1983-2016 (projected)

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 reflect.

Historical and projected commodity bull and bear market pricing actions

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.

Appendix 3: Stock bear markets typically occur in recessions

P=P/E x E
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/E’s” 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.

S&P 500 year over year percent change showing recesssions and fed tightening from 1969 to 2014

As always, we remain focused on understanding the current trends in fundamentals because it gives us the best probability for success.

Sources & Notes

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