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

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