By Polya Lesova
It was a shot that hurt around the world.
In August 2007, France's biggest bank froze withdrawals from
three of its investment funds, blaming the "complete evaporation"
of liquidity in certain parts of the U.S. securitization market.
BNP Paribas couldn't fairly value the mortgage-backed securities
its funds held, because there were no buyers for the assets.
BNP's announcement spooked financial markets. A major
international bank acknowledging problems with subprime mortgages
opened a fissure that by September 2008 had developed into the
worst financial crisis since the Great Depression.
Five years later, the U.S. has come a long way. The economy is
expanding, the housing market is recovering and the financial
sector is much healthier.
But the ghosts of 2007 and 2008 still haunt the markets. The
banking and housing sectors are both stronger, to be sure, but are
vulnerable to market shocks and headline risk. Meanwhile, after
suffering through two bear markets in the past 12 years, individual
investors have lightened up on stocks in favor of bonds.
These concerns, along with the looming U.S. fiscal cliff and the
euro-zone debt crisis, will likely be on Ben Bernanke's mind as the
Federal Reserve chief prepares his speech at the Fed's Jackson
Hole, Wyo., conference in late August.
"What we had going into 2007 and 2008 was a U.S. housing and
banking crisis of historical proportions," said David Rosenberg,
chief economist and strategist at Toronto-based investment firm
Gluskin Sheff + Associates.
Now, "One of the critical differences is that much, if not all,
of the bad news in the residential real estate sector is behind
us," Rosenberg said. "The banks are in much better shape than they
were in 2008 and 2009 when their very existence was being put in
question in the marketplace."
Back from the brink
Though few realized it at the time, BNP's announcement would
unleash a chain of events that brought the financial system to the
brink of collapse in September 2008 when Lehman Brothers
failed.
Confronted with a burst housing bubble and financial
institutions loaded with toxic assets tied to real estate, the U.S.
government spent billions of dollars on a bailout for the financial
sector, and the Federal Reserve launched a range of unconventional
monetary-policy measures to support the economy.
These unprecedented efforts have yielded results. U.S. GDP and
employment are both growing, albeit at low levels. The housing
market is gradually recovering, with the gap between supply and
demand narrowing. Banks have built up capital, reduced leverage and
tightened lending standards. The Dow Jones Industrial Average has
doubled in value since its low of March 9, 2009.
Yet for all of this progress, the market's demons haven't been
completely exorcised. For one, the U.S. economic recovery has been
frustratingly slow and the jobless rate has held above 8% for three
years.
Financial institutions now have to adjust to a regulatory
environment aimed at improving accountability, curbing risk-taking
and protecting consumers from abusive practices. Questions have
been raised about the structure and size of the nation's biggest
banks, with some observers -- including Citigroup architect Sandy
Weill -- calling for their breakup. Several banks also face
investigation into whether they manipulated interbank lending rates
during the crisis for their benefit.
Banks face a "new and very intense regulatory regime that makes
it difficult to take risks," said Jason DeSena Trennert, managing
partner and chief investment strategist at Strategas Research
Partners LLC.
Regulations are still in flux and "it's hard to make plans for
your business without knowing what the rules are," Trennert said.
The Dodd-Frank financial-reform act became law in July 2010, but
only about a third of the rules have been finalized.
The Financial Select Sector SPDR Fund (XLF), for example, which
tracks financial stocks in the Standard & Poor's 500 Index, has
gained almost 19% in the past 12 months. But an investor who bought
this exchange-traded fund three years ago is essentially flat,
while a shareholder from five years ago has lost more than half of
his investment.
"It's going to take time for the banks' long-term business model
to become clear," said Neel Kashkari, head of global equities at
mutual-fund giant Pimco. As a Treasury Department official in 2008,
Kashkari oversaw the federal bailout for the financial sector known
as TARP.
"The banks have a lot more capital and a lot less leverage, so
their return on equity is lower than they are used to," Kashkari
said. "A lot of the banks are trading for less than tangible-book
value."
As for the housing market, many indicators point to a gradual
rebound, driven by a substantial drop in the supply of properties
and modest improvement in demand. Home prices are rising, with
particularly sharp increases seen in regions such as Phoenix, Ariz.
and Oakland, Calif.
"Our view is that the housing crash in the U.S. has ended, the
market has reached a bottom and is now in a slow and modest
recovery," said Paul Diggle, property economist at Capital
Economics. "You've seen that in activity indicators such as sales
for at least a year now."
Yet a meaningful recovery could be years away. Michelle Meyer,
senior U.S. economist at Bank of America Merrill Lynch, sees three
main reasons why the pace likely will be slow: "Anemic economic
growth, challenging credit conditions, and the overhang of
distressed properties."
Follow the money
Against this cloudy backdrop, mutual-fund investors have exited
stock funds en masse for the perceived safety of bond funds. Bond
king Bill Gross, Pimco's founder and co-chief investment officer,
recently argued that "the cult of equity is dying."
And a chain of market snafus -- such as the Knight Capital
trading glitch and the Facebook initial public offering -- have
damaged confidence.
"Unfortunately, there has been a series of events that has led
the average person to believe that the system is rigged against
them -- and not without some justification," said Trennert, the
Strategas Research strategist. "Having said that, I also believe
that buying bond funds when interest rates are this low carries a
risk with it that I don't think the average person
understands."
So what is an investor to do?
Pimco's Kashkari emphasized the importance of a diversified
portfolio to withstand all types of economic scenarios. "Bill
[Gross] said the cult of equities was dying, not equities,"
Kashkari said. "Returns across asset classes are going to be lower
in the future, but we still believe stocks can generate a positive
return."
"Investors should be diversified globally by region and by asset
class," Kashkari advised. His team actively picks stocks rather
than sectors. For instance, he likes Kia Motors Corp. (000270.SE),
the South Korean car manufacturer; and ViewPoint Financial Group
(VPFG), a small bank based in Texas.
Gluskin Sheff's Rosenberg said high-yield corporate bonds
present attractive opportunities given the robust health of
corporate balance sheets.
"In this new paradigm, interest rates are at extremely low
levels. You will preserve capital in the government bond market but
you will not build wealth," Rosenberg said. "Corporate credit
remains a very solid place to be."
Rosenberg also believes investors can make money in slices of
the equity markets. He likes companies that are not tied to the
direction of economic growth and have a consistent record of
dividend growth.
The consumer staples, health care, telecommunications services
and utilities sectors are among his favorites.
For example, in a report to clients in July, Rosenberg
highlighted Hershey Co.(HSY) , Beam Inc. (BEAM) , Home Depot Inc.
(HD) , AutoNation Inc. (AN) , General Growth Properties Inc. (GGP)
and Ascena Retail Group Inc. (ASNA).
"Buying the index is not the answer," Rosenberg said. "Buying
the right sector is the answer."
-Write to Polya Lesova at AskNewswires@dowjones.com