The day after the Dow Jones Industrial Average dropped more than 300 points, vaporizing its gains for the year, two legendary chief investment officers shared sometimes-conflicting views on the U.S. and global economic outlook, interest rates and the markets, and the best alternative investments.

One thing they did agree on: Investors face a number of risks in the next few years.

“‘Uncertainty’ is clearly the watchword today,” said Mark Yusko, CIO of Morgan Creek Capital Management, at the fifth annual Innovative Alternative Investment Strategies conference in Denver last week.

George Kellner, CIO of Kellner Capital and an innovator in the risk arbitrage business for over 30 years, told the audience of about 700 financial advisors that if they think the world is dangerous, they should invest in predictable things that have outcomes. “The event business—the merger business specifically—has lots of wind at its back,” he said.

It’s impossible to predict markets or extraneous events, such as conflict in Ukraine and debt default in Argentina, which roiled markets last week, Kellner said. “But you can predict an outcome as to whether Company A and Company B are going to get together or not,” he said.

Kellner said he doesn’t see a recession on the horizon because of almost unanimous consensus among economists for slow growth in the U.S., defined as about 2.5 percent, over the next 24 months. The bull market “still has some legs. It’s oldish, but it’s not dead yet,” he said.

The U.S. and the rest of the world will be OK, Kellner said, but he did note one powerful wildcard when it comes to economic forecasting. “I would watch the Federal Reserve very carefully,” he said. “I think they have a way of screwing things up in a manner that is unique.”

Strongly disagreeing with Kellner, Yusko, who once served as CIO for the University of North Carolina at Chapel Hill, said he believes a recession is on its way because the growth rate since the recovery started has really been around 2.0 percent or a little less. “That’s the slowest ever in history other than the Great Depression for an expansionary recovery. That’s not good,” he said.

Yusko said he doesn’t know what will cause the next recession or exactly when it will begin, but he believes it could arrive this year or next. “It will start when the Fed does the tightening. It always does,” he said. “Everybody says tapering is not tightening. It is. It’s removing liquidity from the markets, so maybe that will be the trigger, maybe it won’t.”

As to the direction of interest rates, Yusko noted that Bloomberg News interviewed 67 economists at the beginning of the year and all predicted interest rates would rise. The economists were “dead wrong” and those who followed their advice and took down the duration in their fixed-income portfolios lost out, he said. “Short-duration fixed income this year has made basically nothing because interest rates are still around zero. And they’re going to be zero for a long time, contrary to what Ms. Yellen says,” Yusko said, referring to Federal Reserve Chairwoman Janet Yellen.

Merger Mania

Yusko offered three reasons why he thinks markets are peaking and headed down. First, merger and acquisition activity historically booms, as it is now in the U.S., at market tops. When markets crest, the value of a country’s currency is high and managers take advantage of “phony money” to buy other companies.

And insiders don’t sell at market bottoms; they sell when they think their businesses are over-valued. “The second thing you see at peaks is a rash of IPOs, and we just had the highest IPO activity since the tech bubble of 2000,” he said.

Third, corporate buybacks always peak right before market tops, as managers repurchase their companies’ stock with money borrowed at low interest rates, he said.

Assuming markets are at or near their summits, Yusko suggested it might be wiser to forgo the profits from any further potential run-up in stock prices and go to cash—to be ready to take advantage of cheap prices in a subsequent bear market. He said it would be even better to buy into a fund such as Kellner’s and make seven or eight percent per year on each dollar invested through arbitrage.

Other Opportunities

Regarding developed markets, Yusko said Japanese equities would outperform U.S. equities over the next 10 years by two- or possibly three-fold. Japanese companies now sell at trough multiples and margins, while U.S. businesses trade at peak multiples and margins. Those concerned with Japan’s debt don’t understand that, as inflation rises, the real value of the debt will decrease and the burden will decline, he said.

While Japan’s aging population is sometimes cited as a “demographic problem,”  Yusko said that’s not an issue. “Japan is not a Japan story. Japan is a Southeast Asia story and three billion people in Asia and Africa are going to turn middle class in the next 20 years,” he said. Population growth will drive a consumption wave, the likes of which the world has never seen, he said, which will benefit the energy and natural resources, consumer goods and telecommunications sectors.
     
Yusko also believes there are huge opportunities in emerging markets. He called mobile phone payments the “biggest trend on the planet right now.”

“Mobile payments started in Nairobi, Kenya. Silicon Savannah is just as hot as Silicon Valley today,” he said.

Besides alternative strategies that take advantage of change and activity, Yusko and Kellner both like private equity. Yusko, whose firm offers a PE fund, said it’s the best asset class because the illiquidity premium is currently double its long-term average. But Kellner warned advisors to stick with name-brand PE firms and avoid the cottage industry of smaller entities that play “charades” by purchasing each other’s products, because somebody else has already culled the low-hanging fruit.

Both CIOs agreed that hedge funds, which have underperformed since March 2009, would likely outperform going forward. Yusko said that in the next three years, long-short equity would “crush” long-only equity. He said long-only equity will not necessarily decline in value; it’s just that he expects long-short strategies to perform significantly better.

Liquid alternatives are another good possibility, Kellner said. “For the right kind of investor, the combination of hedge fund investment skillsets with the liquidity and the transparency and the more friendly fee structure of mutual funds is a very powerful combination,” he said.

An advisor in the audience asked whether there was any danger that the Fed would lose control of the economy.

“Central banks don’t lose control. They are the control,” Yusko responded.

But Kellner said he had no idea what would happen when the Fed stops tapering and interest rates start to rise. “I just don’t know what the markets will do when in fact the punch bowl is removed,” he said.