Toro's Running of the Bulls Market Blog

Market Action 2/28/07

The market stabilized today on Ben Bernanke's testimony at the House Budget Committee.  Helicopter Ben said that, basically, everything is fine.  I had figured the Chopper would have said something like in the caption above.  Who would have thought the Fed Chairman  would have said something to calm the markets after stocks plunged around the world?  Truly, I am shocked.

We'll chalk one up for the bulls today, though it sure was a tepid response, considering it wasn't the end of the month when mutual funds and hedge funds don't mark up their favourite holdings (wink, wink).  The Dow ran up 110 points in the first hour, only to too and fro for the rest of the day. Perhaps most tellingly, the market didn't hold in the final hour, selling off, with the Dow closing up 52 points.  But since we didn't plunge another 4%, I guess it was a good day.

Bubblevision had a parade of market commentators on camera today (as, in fairness, did BloombergTV, though BloombergTV seemed to have roughly an equal amount of bears on as well), and the overarching theme of those market participants - most whom have a vested interest in keeping you in the market, and thus keeping their fat paycheques fat - was that "nothing had changed." Well, that's not correct, since what "changed" was that the market, which had gone up in a straight line the past eight months, fell by nearly 3%-4%.

I am always a little bamboozled by this explanation, especially from guys with gray hair.  The underlying premise of this argument is that the market is always an accurate discounting mechanism of the economy.  If this is true, this means that markets are efficient, so what the hell are these guys doing on TV anyways, since if the market is so ruthlessly efficient, we should all be in index funds?  A more accurate description is that markets are efficient discounting mechanisms over the long-run. 

Remember that from 1966 to 1982, the Dow went up exactly 0% in nominal terms, and didn't earn a real return until 1991, whereas the economy grew by about 3% per year, each year. (Inflation? Hello! - ed.)  And have we forgotten the melt-down in the Nasdaq, which fell 77% top to bottom, and where best-in-breed companies like Cisco fell 90% in two years?  Simply because "nothing has changed" in the economy - if true - that doesn't mean markets cannot fall, and fall hard.  Or if something does change in the economy, the moves cannot become exacerbated, as they were when when we went into a mild recession at the beginning of the decade whereas the Nasdaq was acting like it was 1929 all over again.

Financial markets are all about confidence.  What changed this week was that investors' confidence declined.  At some point, it had to.  We were at an all-time high in confidence.  Risk wasn't being properly priced in the market.  It still isn't (except perhaps in the submerging prime market).  Spreads are still too narrow in junk and emerging market bonds.  The VIX may have spiked, but volatility is still low.  Cross-sectional volatility within and amongst asset classes collapsed over the past four years.  Is there any evidence that it has widened appreciably over these past two whole days?

Financial markets are also all about liquidity, and there is an ocean of liquidity around.  But that may be changing.  A rout in the emerging markets, widening of spreads, and a rise in the yen are all events that take liquidity out of the system.

The other fact that seems to be escaping many American commentators is that even though the Fed has been on hold, other central banks around the world have not.  The ECB has been raising rates, the BoJ has started raising rates, though tentatively, and China has been tightening credit for the past two years, or trying to anyways.  Recently, China increased the reserve ratio for banks to 10%.  That's a blunt instrument.  American commentators who say "nothing has changed" are ignoring the fact that monetary conditions overseas are getting tighter, i.e., the global yield curve has been flattening. And it has been overseas liquidity that has played a significant part in driving asset markets and keeping the US economy buoyant.

Apart from tightening monetary conditions, earnings growth is slowing, margins have peaked, corporate balance sheets are becoming more leverage, and risk is coming back into the market.  There are all sorts of reasons for the market to go down. 

And we're not done going down yet.

THUD! - Market Action, 2/27/07

Quite the day today, eh? 

You always feel a little stupid buying a stock the day before the market cracks, like I did yesterday, buying a gold stock and a coal trust.  However, you feel good selling stocks the day before, as I did yesterday with the mortgage REITs.  You also feel really, really good when you realize you are very long gamma via the put options you own.  Today, I went from being under-hedged to being over-hedged as the market decided risk was back in style and bid option premiums up across the board.  Option premiums have been ridiculously cheap.  Now they are not, and if you owned put options, they are suddenly much more valuable than they were yesterday.  Thus, I wound up having my best day of the year today.

There is absolutely no doubt that today was a pivotal day in the market.  I have been expecting this for a few months now, though I had no idea it would happen today.  Of course, I had no idea that the Chinese government would be clamping down on rampant speculation either, but that's what makes the market so interesting, especially when market participants aren't pricing risk properly.

Don't let the bullish/pollyannish market commentators on Bubblevision, BloombergTV, ROBTV, etc., lull you into a sense of complacency.  The market is damaged and the tone has changed.  The S&P 500 rose 20% in eight months, with nary a bump along the way, while the bull market has been going on a full four years.  Bull markets don't go on forever.  Eventually the bear growls, and it did so today in a big, big way.  We smashed through the downside boundary of the recent uptrend, and went through the 50-day like it wasn't even there.  Whereas for the past four years, dips were to be bought, now, rallies are to be sold and shorted.  Even if we rally tomorrow, the uptrend has been broken.  Now, the goal is to protect capital.

Also of significance was the sell-off of the dollar to the yen.  Japan has been a big source of liquidity as it seems every single bank and every single hedge fund was borrowing cheaply in yen and buying anything risky elsewhere.  Today, that trade lost money.  We'll see if the yen carry trade begins to unravel.  If it does, the fireworks have just begun.

The fun has started.  Strap yourself in and protect your savings.

Market Action 2/26/07

I thought today was a fascinating day in the markets.  All last week was captivating, but today there were very interesting tells.

First, the brokers.  The brokers are selling off, some of them hard, like Lehman.  Though it sold off today, the Central Bank of the World, aka Goldman Sachs, has not broken its near term uptrend, but most of the other brokers have.  Merrill is back to where it was at the beginning of December, Bear Stearns has done nothing the past few months, and Lehman looks like a stock you'd short on any bounce.  Of course, the brokers with the submergingprime exposure are the ones that have been hit hard, but I think its pretty difficult for the market to do well if the brokers aren't participating, at least in the intermediate term.

Another fascinating stock has been Moody's.  It is getting clocked, and, in a matter of days, has given up all its gains since October.  With the submergingprime market collapsing, estimates may have to come down as the rocket scientists won't be able to throw any garbage into a structured product anymore, which means there will be less for Moody's to rate.  Also, the company got raked for rating a few Icelandic banks AAA. However, the problem is in the submergingprime market.

What's worrisome about the brokers isn't their exposure to the submergingprime market per se.  I don't know the inventories specifically, but my understanding is that the direct exposure is pretty small.  The bonds were written then sold off as a derivative to someone, somewhere.  The question is, where?  Most likely, there are hedge fund cowboys who have some of this garbage on their books.  And the brokers have lent a whole lotta money to those cowboys.  If their books are marked down, the brokers and the banks will be on the hook for the liabilities, which could set off a chain reaction.  My own belief is that when we are hit by a crisis - and its a matter of "when", not "if", the only question is the severity - it will happen very fast.  Just like the sell-off in Moody's stock.

There was panic in the air as bids evaporated for Citigroup early in the afternoon.  I was on a call with my Smith Barney broker, and we marvelled as we watched Citi swoon down a point almost effortlessly in the few minutes we'd been on the phone.  Well, I marvelled while he fretted since, though I own some stock in Citi, he has a significant part of his net worth tied up in the company.  I have been wrestling what to do with the stock.  On the one hand, I knew this was coming.  On the other, I have a hard time selling a stock yielding 4% with a CEO that is on a short leash.  So I sit on my hands.

I had no problem blowing out my passive mortgage REITs.  I bought a basket back in late summer, expecting these REITs - which invest in mortgage bonds and derivatives financed by equity and debt - to appreciate when the Fed started cutting rates.  These vehicles did enormously well at the end of 2001/beginning of 2002 when the yield curve steepened. I expected a similar occurrence as I figured the Fed would start cutting rates to absorb the sell-off in the housing market.  I am now far less sure the Fed will move anytime before Autumn, and thus the rationale for owning these REITs has disappeared.  My basket rose about 10% and paid 5% in dividends, so the return wasn't bad, but I was hoping for more.  I do believe there will come a time when you will want to own these things big, and I may revisit the group later in the year.

As for the active REITs, I'm dying to short them.  Due to restrictions at work, I cannot short stocks. But I can short ETFs, and the DJ Wilshire REIT ETF - ticker RWR - is the one I'm eying.  It is yielding less than 3% and is sitting right here on near-term resistance.  REITs are ridiculously over-owned and over-valued.  In 2000, they were yielding around 8%.  A yield of 8% would put RWR at $35.  Today its at $96.  Don't know if its going to fall that far, but there's a whole lot of downside if investors turn on the group.  There is a near frenzy in parts of commercial real estate, with almost a hysteria of bidding for some properties that seems to make little sense.  I plan to start building a short position soon.

On the other hand, the semis look really good.  Whereas its hard to envision the market going up with the brokers not participating, its hard to see the market falling with the semis perking up.  Of course, historically the semiconductors have been the beta's beta play - which is why they've been so much fun and why I've lamented the lack of volatility in the group - so they can turn in a heartbeat.  However, I was looking at stock after stock in the chip sector last weak, and though they aren't dirt cheap, the charts appear to be bottoming for many of them.  With news that inventories are correcting, the stocks could easily fly 40%, 50%, 60% over the next few months, even if the brokers are struggling.  Or at least that's how they've behaved in the past.  Heck, that may be easy, what with private equity apparently sniffing around AMD.

Another group that looks fascinating are coal stocks.  I purchased a Canadian coal trust company today that smashed through near-term resistance this afternoon, and is setting up in my absolute favourite chart pattern.  I love stocks that have cracked, bottom, rise, then sell-off again but bottom higher than the first bottom before shooting through the near-term highs, beginning another up-leg.  I've been perusing the American coal stocks, and they look very interesting.  They sold off today on the news that KKR's purchase means TXU will build less coal plants, but I think that's probably noise.

By the way, did you see some of the other utility companies?  Constellation Energy was up over $6 before settling down.  A few months back, I wanted to take a position in the independent power producers such as Mirant and NRG.  Excess generation capacity is slowly diminishing.  I love supply squeezes, and you may begin to see tight capacity by the end of the decade.  But the stocks have run, and I never got in.  Now they look expensive to me.  Of course, rumours were flying that the likes of Mirant is a target for private equity, which I think is hilarious.  Not that it couldn't happen, because in this environment, anything could happen.  However, the idea that private equity would even consider the IPPs would have seemed preposterous just a few years ago.  There is nothing more commoditized than electrons, except that other commodities can be stored while electrons cannot, hardly a typical LBO candidate.  And let's not forget that the whole group was pretty much bankrupt a few years ago.  Now, private equity will buy anything, apparently, no matter how volatile.  Sign of the times, no doubt.  Gotta earn those fees!

Speaking of buying, I continued to build my gold position today.  I bought a large, well-known, American-domiciled producer that has been underperforming as of late.  I know, I know, buy the juniors because the majors will take the juniors out. My problem is that I have a hard time buying at or near the highs, which is where many of the smaller gold companies are trading.  The hardcore value investor in me wants to find a bargain, and this stock is trading off nearly 20% from its 52-week highs.  But gold is in a bull market and they'll all go higher. 

Even though there have been a whole lot of cross-currents in the market as of late, the S&P 500 is approaching the near-term trend line.  Since January, the market has bounced off the bottom end of its trading range, which is around here.  Today's broad-market action, with the S&P 500 off a mere 2 points, gives me no reason to think the pattern has changed.  However, the action in the brokers, Citi, Moody's, etc., gives me pause.  Its not healthy when the financials are struggling.  I haven't delta-hedged my portfolio as I've let my puts decay as I've been waiting for a tell in the market before hedging out my position. The action in the brokers may be that tell.  But on the other hand, the semis are doing well, despite the sell-off today in the group.  And with energy, gold and silver all doing well, that's where I want to play. 

Be Careful Out There!

Michael Steinhardt is looking for the end of the rally.

``Very few people have the ability to pick a high, and I don't think that this is the exact moment,'' Steinhardt, 66, said in an interview yesterday in New York. ``One stays long, but one becomes very sensitive. You say to yourself that the next major, major move is going the other way.'' 

Steinhardt said some investors were using too much debt to boost returns, and the dollar may get support from a decline in the U.S. budget deficit. ...

Steinhardt sees greater risks now than in the past from the potential for stocks to decline ``in a meaningful way,'' defined as by 10 percent or more.                

``Coming back to the area where the excess might be, I think it's in leveraged investments,'' including commodities and real estate, he said. ``The rules related to borrowing money have loosened up extraordinarily. This is something we should remember.'' ...

Recent moves by some hedge funds to sell shares publicly don't make sense, Steinhardt said.         

``I wouldn't buy a hedge fund in a public market,'' he said. Shares of New York-based Fortress Investment soared almost 70 percent on Feb. 9, their first day of trading.         

``I wouldn't buy Fortress,'' he said. ``Firstly, its assets go up and down in the elevator every day, and No. 2, it has a limited history of success, and No. 3, even if it had a longer history of success, it doesn't seem to me the sort of thing that has durability.''

By the way, don't buy Steinhardt's biography.  I thought it was a waste of money.  Steinhardt is a hedge fund legend.  I was dying to learn about his investment philosophy, but he rarely discussed it at all.  The book was a great disappointment.

Oh, and case you missed it, margin debt hit an all-time high, surpassing the previous record set in 2000.

The amount of money borrowed from brokerages that do business on the New York Stock Exchange to buy stock reached a record $285.6 billion last month, topping the prior high set at the peak of the so-called Internet bubble.

Changes in the level of margin debt, as the borrowing is called, have mirrored those of U.S. stock indexes. After setting an all-time high of $278.5 billion in March 2000, margin debt dropped to less than half that amount by September 2002.

Firefox and IE

I apologize to those of you who are viewing this blog in IE.  I use Firefox and format this blog in Firefox.  Not being particularly technically adept, it never occurred to me that the format would look different in IE.  I only noticed it when I was traveling last week and the only option on the hotel computer was IE.  I'm trying to get to the bottom of this.  In the mean time, I am trying to format in such a manner that it looks good in both browsers.  That's a bit of a pain, but I will do my best.

Submergingprime

The "sudden" news of the past week or so is the implosion in the subprime market.  The bulls are saying it will be contained to that market and not have an impact on the rest of the economy.  They may be right.  Or, they may not.  Time will tell.  But I think it would be foolish to not at least have some protection to the downside because melt-downs can happen very fast, especially with all the leverage in the derivative structures underlying much of this stuff.

The action in Lehman's stock on Friday, wasn't good.  It fell with a thump.  I have a hard time believing the market will go up for any period of time without the brokers participating.

The WSJ notes

Nearly 1.2 million foreclosure filings were reported last year, a 42% rise from 2005. That is a rate of one in every 92 U.S. households.
 
• Colorado, Georgia and Nevada had the nation's highest foreclosure rates last year, according to RealtyTrac. Among the top 100 metropolitan areas, Detroit, Atlanta and Indianapolis topped the list.
 
• About 80% of subprime mortgages today are adjustable-rate mortgages, or ARMs, that have been nicknamed "exploding ARMs" because they have low fixed-interest payments in their first few years but then usually adjust to higher interest payments.
 
• Creative new subprime loans -- "piggyback," "interest-only," and "no-doc" loans, among others -- accounted for 47% of total loans issued last year. At the start of the decade, they were less than 2% of total mortgage loans.
 
• Borrowers have never been more leveraged. Loan-to-value ratios, the loan amount expressed as a percent of the property value, have grown to 86.5% last year from 78% in 2000.

The cost of insurance on CDSs has quadrupled the past six months.

Of course, Wall Street is telling you not to panic.

Mr. Levkovich’s words echo similar comments from Richard Berner of Morgan Stanley, who argued earlier this week that such fears of a wider credit crunch are “dramatically overblown.” Subprime loans have increased, accounting for “$605 billion or 11% of the $5.5 trillion in outstanding securitized mortgages (which in turn account for 54% of all mortgages outstanding),” but Mr. Berner points out that “disciplined industry lenders” have not experienced early payment defaults, unlike more aggressive lenders.

The last time subprime delinquencies were rising, the economy was going into a recession.  Now, however, delinquencies are rising and the economy is not in a recession.  Wall Street says not to panic, but there is no doubt subprime is a much more important market than in the past.

Still, the rising delinquency and foreclosure rates are concerns because the subprime segment has grown so quickly. It now comprises 23% of the U.S. mortgage market, up from 8% in 2001.

"The performance of the sub-prime market is significant because it has rapidly grown from a niche market into a major economic force," the CRL report said.

No surprise that subprime derivatives indices are getting hammered.

A derivatives index used to bet on bonds backed by the riskiest U.S. mortgages fell for the fourth straight week as more subprime lenders reported losing money.         

Prices for credit-default swaps linked to 20 securities rated BBB-, the lowest investment grade, and created in the second half of 2006 fell 2.8 percent to 82.82 this week, and are down 15 percent since being introduced Jan. 18. The decline means an investor this week would have paid more than $950,000 a year to protect $10 million of bonds against default.         

The tumble is being exacerbated by hedge funds using the index to make bearish bets and a dearth of investors willing to use them to make bullish bets, said investors such as Dean Smith of New York-based Highland Financial Holdings Group LLC, which manages $2 billion including mortgage bonds. The cost to protect against default using the index was more than two-and-a-half times that to insure individual securities on Feb. 12, Bear Stearns Cos. said. ...

Falling prices for the ABX-HE-BBB- 07-1 contracts, and ones tracked by other ABX indexes, accelerated last week, as the two biggest subprime home lenders, HSBC Holdings PLC and New Century Financial Corp., said more of their loans were going bad than they expected. Subprime mortgages are made to borrowers with low credit scores or high debt burdens. New subprime loans are experiencing more delinquencies than in at least six years.         

`Pure Sentiment'         

ABX indexes plunged last week even as typical yield premiums on BBB- bonds remained at about 3 percentage points over the one month London interbank offered rate, according to RBS Greenwich Capital Markets. Typical swap premiums on a single bond rose by $50,000 per $10 million to $400,000, versus a $235,000 rise for ABX premiums to $918,000, according to Barclays Capital.         

                           

Are the cracks in the subprime market a replay of the 1998 meltdown and the collapse of Long-Term Credit Management?

The trickle of bad news in recent months resembles a slow-motion version of 1998's credit crunch following Russia's debt default of that year and the unraveling of hedge fund Long-Term Capital Management. Back then, the flight-to-quality into U.S. Treasury notes and bonds, along with investors' unwillingness to purchase securities backed by subprime mortgage loans, led to the eventual bankruptcy in 2000 of companies such as ContiFinancial, a former unit of grain giant Continental Grain. An ill-timed bet into specialty lending by life insurer Conseco—which bought Green Tree Financial, a leading lender in the manufactured home market, in 1998—played a considerable part in Conseco's bankruptcy in late 2002.

Wall Street won't help you.  Not only are firms such as Lehman and Bear Stearns big players in the mortgage market, they have underwritten the paper of these subprime players.  And we all know the denouement of this arrangement.  Its not like we haven't seen it before.

My own belief is that the meltdown in the subprime market is a shot across the bow for investors.  Risk can only get pricier, and there will be sudden sharp sell-offs - like we're seeing in the subprime market now - in other markets later.  This will effect most other asset classes, including stocks.  I think the question is will the damage be contained?  For that, I don't have an answer, but my bet is that there will be some pain.

A Rerun of the 1990s?

The New York Times published an article recently about how this economic expansion looks much like the last one.

It is five years into an economic expansion and most Americans are still waiting for their share. Inflation is swallowing pay raises. Businesses are hiring, but forecasters worry that the economy may be about to stall.

“If this is a recovery,” the leader of the political opposition complains, “I can hardly wait for the recession.”

This may sound like the stuff of today’s headlines. But it comes from 1996, when Bill Clinton was president and his rival was Bob Dole, the Republican nominee. The economic expansion in question, which got off to a sputtering start in March 1991, was to become the longest period of uninterrupted growth in the nation’s history.

Now, a little more than five years into an expansion that officially started in November 2001, the economy is showing remarkable parallels to the situation of a decade ago. “It’s striking how similar they are,” said Robert J. Gordon, an economics professor at Northwestern University.

The overall rate of growth has followed a trajectory almost identical to the first five years of the 1990s expansion. Now, as then, corporate profits have surged; the stock market has, too. But just as workers have finally begun to reap some of the spoils of a growing economy, many forecasters worry — as they did a decade earlier — that the expansion is running out of steam.

What is striking, considering these similarities, is how little effect the policy choices of Democratic and Republican administrations seem to have had on how both growth cycles played out.

That last sentence is, I believe, particularly poignant.  Politicians and their assorted cheerleaders put too much emphasis on policy regarding the US economy when, in fact, the US economy is enormously resiliant and dynamic, regardless of what the politicians say and do.

Wage increases have, indeed, been slow in coming. In December, 61 months after the economy started to grow, the wages of production and other nonmanagement workers were barely 1.7 percent higher, after inflation, than when the economy hit bottom in November 2001. Most of those gains came in the last few months.

But many people have forgotten that, initially, the expansion of the 1990s was also called a “jobless recovery,” and then a “joyless” one, when employment started growing but real wages did not. In April 1996, 61 months into that growth cycle, the hourly wages of nonmanagement workers were actually worth 0.4 percent less, after inflation, than when the expansion began. ...

Indeed, the share of the economy devoted to workers’ compensation shrank as much in the first five years of the 1990s expansion — to 56.3 percent, from 57.7 percent, of gross domestic product — as in the most recent five years, when it fell to 56.6 percent, from 58.1 percent.

$50 Billion Private Equity Deal?

You know that when we look back at this time, the telling feature of the top will be a mega private equity deal.

Well, we're getting close as KKR is rumoured to be taking TXU out.

Kohlberg Kravis Roberts & Co. is poised to buy Texas utility owner TXU Corp. in the biggest-ever leveraged buyout.                

The board of Dallas-based TXU is set to vote on the proposal this weekend, said a person familiar with the deal who declined to be named because the talks were private. Texas Pacific Group may be part of the acquisition, according to the Wall Street Journal, citing unidentified people. The possible TXU sale was previously reported by CNBC.      

The purchase price is not yet final, the person said. Shares of TXU surged as high as $70 in after-hours trading, valuing the company at about $32 billion. With TXU's $16 billion in debt, the transaction may be worth more than $48 billion. Blackstone Group LP's purchase this month of Equity Office Properties Trust for $39 billion, including debt, was the largest previous buyout.      

``An acquisition by KKR will be a blow to TXU's credit quality because leverage would increase substantially,'' said Sean Egan, managing director of Egan-Jones Ratings Co. in Haverford, Pennsylvania. ``Leveraged buyouts of utilities have been relatively rare.''

First semiconductors, now utilities.  There's too much money floating around the world.

In other signs of a top via private equity, the largest specialized fund has been raised

Providence Equity Partners, a private firm that focuses on media and communications, is expected to announce today that it raised $12 billion for what would be the largest specialized fund in the world, according to people briefed on the matter. Providence owns stakes in businesses including Metro-Goldwyn-Mayer and Warner Music.

A number of supersize private equity funds have been raised in the last year as pension funds and other investors awash in cash have piled into this growing industry. The Blackstone Group and Kohlberg Kravis Roberts & Company are close to announcing funds worth more than $20 billion, while Goldman Sachs is near completion of a $19 billion fund and Texas Pacific Group just raised $15 billion.

For Providence, which acquired Univision in a heated auction last fall, the new fund is almost three times the size of its last one, which was $4.25 billion, raised in 2004. The huge amount of money will probably put pressure on Providence to seek bigger acquisitions and perhaps cast its net a bit farther afield. The size of the fund will also allow Providence to hunt for deals alone or with fewer partners. Several of the more prominent deals that Providence has pursued were as part of consortiums.

And perhaps the most time-tested indicator of a top in the making, MBAs are flocking to private equity, making it the number one destination for Harvard grads

Thirteen percent of Harvard Business School's 2006 MBA class took jobs in private equity, making it the most popular finance destination, topping even investment banking. At Stanford Graduate School of Business, the percentage of graduating MBA students taking the private equity path has steadily risen since 2002 and rose to nearly one-tenth of the class last year.

Profit Margins Unsustainable?

That is what Doug Kass writes, and I agree.

He includes an excellent graph from Contrarian Edge, which expounds on the same topic.

Forecasted profits for the S&P 500 are currently $92. With the market closing at 1456, that means the market is trading at 15.8x estimates, which sounds reasonable.  However, at the historical profit margin of 8.8%, profits would be $65.  Thus, the market is trading at 22.3x "normalized" profits.

Edmund Phelps on the Lack of Entrepreneurialism in Europe

Mr. Phelps is the 2006 winner of the Nobel Prize in economics.

These are exerts from his recent article in the Wall Street Journal.

As is increasingly admitted, the economic performance in nearly every Continental country is generally poor compared to the U.S. and a few other countries that share the U.S.'s characteristics. Productivity in the Continental Big Three -- Germany, France and Italy -- stopped gaining ground on the U.S. in the early 1990s, then lost ground as a result of recent slowdowns and the U.S. speed-up. Unemployment rates are generally far higher than those in the U.S., U.K., Canada and Ireland. And labor force participation rates have been lower for decades. Relatedly, the employee engagement and job satisfaction reported in surveys are mostly lower, too.

It is reasonable to infer that the economic systems on the Continent are not well structured for high performance. In my view, the Continental economies began to be underperformers in the interwar period, and have remained so -- with corrective steps here and further missteps there -- from the postwar decades onward. There was no sense of a structural deficiency during the "glorious years" from the mid-'50s through the '70s when the low-hanging fruit of unexploited technologies overseas and Europeans' drive to regain the wealth they had lost in the war powered rapid growth and high employment. Today, there is the sense that a problem exists. ...

Many economists attribute the Continent's higher unemployment and lower participation, if not also its lower productivity, to the Continent's social model -- in particular, the plethora of social insurance entitlements and the taxes to pay for them. The standard argument is fallacious, though. The consequent reduction of after-tax wage rates is unlikely to be an enduring disincentive to work, for reduced earnings will bring reduced saving; and once private wealth has fallen to its former ratio to after-tax wages, people will be as motivated to work as before. ...

In my thesis, the Continental economies' root problem is a dearth of economic dynamism -- loosely, the rate of commercially successful innovation. A country's dynamism, being slow to change, is not measured by the growth rate over any short- or medium-length span. The level of dynamism is a matter of how fertile the country is in coming up with innovative ideas having prospects of profitability, how adept it is at identifying and nourishing the ideas with the best prospects, and how prepared it is in evaluating and trying out the new products and methods that are launched onto the market.

There is evidence of such a dearth. Germany, Italy and France appear to possess less dynamism than do the U.S. and the others. Far fewer firms break into the top ranks in the former, and fewer employees are reported to have jobs with extensive freedom in decision-making -- which is essential at companies engaged in novel, and thus creative, activity. ...

There are two dimensions to a country's economic model. One part consists of its economic institutions. These institutions on the Continent do not look to be good for dynamism. They typically exhibit a Balkanized/segmented financial sector favoring insiders, myriad impediments and penalties placed before outsider entrepreneurs, a consumer sector not venturesome about new products or short of the needed education, union voting (not just advice) in management decisions, and state interventionism. Some studies of mine on what attributes determine which of the advanced economies are the least vibrant -- or the least responsive to the stimulus of a technological revolution -- pointed to the strength in the less vibrant economies of inhibiting institutions such as employment protection legislation and red tape, and to the weakness of enabling institutions, such as a well-functioning stock market and ample liberal-arts education.

The other part of the economic model consists of various elements of the country's economic culture. Some cultural attributes in a country may have direct effects on performance -- on top of their indirect effects through the institutions they foster. Values and attitudes are analogous to institutions -- some impede, others enable. They are as much a part of the "economy," and possibly as important for how well it functions, as the institutions are. Clearly, any study of the sources of poor performance on the Continent that omits that part of the system can yield results only of unknown reliability.

Of course, people may at bottom all want the same things. Yet not all people may have the instinct to demand and seek the things that best serve their ultimate goals. There is evidence from University of Michigan "values surveys" that working-age people in the Continent's Big Three differ somewhat from those in the U.S. and the other comparator countries in the number of them expressing various "values" in the workplace.

The values that might impact dynamism are of special interest here. Relatively few in the Big Three report that they want jobs offering opportunities for achievement (42% in France and 54% in Italy, versus an average of 73% in Canada and the U.S.); chances for initiative in the job (38% in France and 47% in Italy, as against an average of 53% in Canada and the U.S.), and even interesting work (59% in France and Italy, versus an average of 71.5% in Canada and the U.K). Relatively few are keen on taking responsibility, or freedom (57% in Germany and 58% in France as against 61% in the U.S. and 65% in Canada), and relatively few are happy about taking orders (Italy 1.03, of a possible 3.0, and Germany 1.13, as against 1.34 in Canada and 1.47 in the U.S.). ...

The weakness of these values on the Continent is not the only impediment to a revival of dynamism there. There is the solidarist aim of protecting the "social partners" -- communities and regions, business owners, organized labor and the professions -- from disruptive market forces. There is also the consensualist aim of blocking business initiatives that lack the consent of the "stakeholders" -- those, such as employees, customers and rival companies, thought to have a stake besides the owners. There is an intellectual current elevating community and society over individual engagement and personal growth, which springs from antimaterialist and egalitarian strains in Western culture. There is also the "scientism" that holds that state-directed research is the key to higher productivity. Equally, there is the tradition of hierarchical organization in Continental countries. Lastly, there a strain of anti-commercialism. "A German would rather say he had inherited his fortune than say he made it himself," the economist Hans-Werner Sinn once remarked to me. ...