Stock options: how to hedge an AI bubble

0:02Jon Fasman:The Economist.

0:10Rosie Blau:Hello and welcome to The Intelligence from The Economist. I'm your host, Rosie Blau. Every weekday we provide a fresh perspective on the events shaping your world.

0:24Rosie Blau:Turkey has been ruled by one man since 2003 He's become increasingly autocratic And also increasingly old Now minds are turning to who might eventually succeed him And a French émigré from Nazi Europe Georges Bochard turned his childhood love of reading into a career As a literary agent he discovered Samuel Beckett Elie Wiesel and many more Our senior culture writer remembers his life.

1:01Rosie Blau:First up, though.

1:10Rosie Blau:Alphabet, Amazon, Meta and Microsoft plan to spend a combined total of$660 billion on AI over the next year. Those massive sums signal the enormous hopes being pinned on the technology. Yet they also make people nervous, because that's a lot of cash to put in before those firms are getting very much out. Making some fear that the price of stocks in the companies going big on artificial intelligence could actually be artificially high.

1:43Josh Roberts:In recent weeks, we've seen big companies announce that they're going to spend absolutely jaw-dropping amounts of money investing in AI.

1:52Rosie Blau:Josh Roberts is our Capital Markets correspondent.

1:55Josh Roberts:Whereas previously, investors were cheering those announcements, actually lately we've seen the stock market wobble in response. It seems like they're getting a bit worried about whether they're going to get returns on all of this money that companies are spending on this new technology.

2:14Rosie Blau:So what exactly is it that's making the stock markets jittery?

2:17Josh Roberts:Well, it's not just that investors are worried about the amounts that companies are spending, although those amounts are vast. It's kind of this feeling that we've been here before. So there are lots of times throughout history where you've had a new technology emerge and it looks like it's going to transform the world. So take railways or canals or electricity or the internet. And in all of those cases, the new technology actually did transform the world. But in the early stages, when it was just coming out, investors got overexcited. They ended up bidding up companies' share prices out of all proportion with their underlying profits.

2:53Josh Roberts:And they also ended up picking the wrong firms, not buying the companies that would actually benefit from this. Then even when the new technology was really successful, a lot of investors lost an enormous amount of money. And there's this worry that something similar is happening again, that AI might be this transformative technology, but share prices have been bid up out of all proportion with underlying profits.

3:16Rosie Blau:So we're at a very nervous moment. What is it then that investors can do to avoid getting stuck?

3:23Josh Roberts:This is something of a puzzle because you might think the obvious answer is, okay, shares are too pricey, so I'm going to sell my shares. Professional investors often don't have that as an option. For example, if I manage a stock fund and I tell clients invest in my fund and I'm going to invest in stocks, I can't just suddenly sell them and sit on a pile of cash. I might actually not be allowed to. Even if I am, my clients are going to ring me up and say, what are you doing? This isn't what I'm paying you for. Even for individual investors who can make the decision to sell their stocks, it's not necessarily a good idea.

3:56Josh Roberts:So take a previous boom, the dot-com boom, which ended in a crash. There were lots of wobbles on the way up. And at each wobble, nervous investors might have decided to sell their stocks. But actually, over the course of that boom, share prices rose by a factor of 12. So you would have really regretted selling your stocks on the way up. And in fact, even after share prices plunged, at the bottom of the crash, investors who had just held on through the ups and the downs would still have made money. Those who had sold out early wouldn't. So selling your stocks isn't necessarily the right thing to do, even if you think share prices are too expensive and you're worried about a crash.

4:33Rosie Blau:So if selling up doesn't make sense, then what else can investors do?

4:38Josh Roberts:Well, the classic way to hedge stock market risk is with bonds. Buy some bonds alongside your stocks. And the reason for this is that bond prices historically have tended to go up when stocks have gone down. So they've cushioned losses. Now, again, looking back at that previous boom, the dot-com one, investors who had hedged their stock market risk with bonds did very well throughout that period. Because actually, bond prices went up as stock prices went up, although not as much. And then when stock prices fell, bond prices rose. So they didn't hurt your profits too much on the way up, but they did compensate your losses on the way down.

5:12Josh Roberts:The trouble today is that we've seen this old relationship break down a bit recently. For example, when stock prices crashed in 2022, bond prices crashed along with them. And what was behind that was the worries were about inflation and inflation can hurt the prices of both of these things. So if we got a similar crash today and lots of investors are quite worried that inflation might cause a crash today, then bonds might not be as effective at protecting people's portfolios as they were in the past.

5:39Rosie Blau:And what about an even older haven, gold?

5:43Josh Roberts:Yeah, well, it's done very well recently. And as you say, this is a time-honoured hedge against chaos. What makes people worried about gold just now is counterintuitively just how well it's been doing recently. It's gone on a roaring bull run over the past year. At the start of this year, traders talk about prices going parabolic, just shooting up and seeming to go towards the moon. What can happen after that, though, is very large swings in prices. And we actually saw that a few weeks ago. The gold price dropped by about 9 % in a single day and then swung wildly afterwards. When you see an asset that is supposed to be a hedge behaving like that, you might feel a little less confident that it's actually going to be a hedge.

6:22Josh Roberts:If it can swing so wildly, is it really a safe haven?

6:25Rosie Blau:And are there any other alternatives then?

6:28Josh Roberts:Counterintuitively, perhaps the best way to hedge stock market risk is with other stocks. So I looked at a study that analysts at Goldman Sachs did recently on hedges that would have performed particularly well during the dot-com bubble. And intriguingly, they found that some of the best ones were select baskets of stocks. So, for example, stocks that pay very high reliable dividends. So they offer you a reliable income. They did well on the way up and the way down during the dot-com crash. Stocks with low volatility is kind of dependable old companies. It might feel a little unsatisfying to say the best way to hedge your stock market risk is with other stocks.

7:05Josh Roberts:But when you look at the alternatives and how these have performed in the past, it might be the best that investors can do.

7:11Rosie Blau:So it does sound like there's no way to bubble proof your strategy.

7:15Josh Roberts:Maybe no way to completely bubble proof it. But there is a boring answer here, which is that the one safest investment strategy is buy and hold for the long term. Investors that rode out the dot-com bubble on the way up and on the way down and then held on for the following years, they still ended up doing very well. The very worst thing you can do is sell your stocks during the depths of a crash when you actually lose your money. The best advice anyone can give is invest slowly, steadily throughout your career while you're saving and just hold on through the ups and downs. Josh, thank you very much.

7:49Josh Roberts:Thanks for having me.

8:09Rosie Blau:The average age of world leaders has been rising. Unsurprisingly, that trend is driven by autocracies. But even if you're desperate to hang on to power, biology will ultimately defeat you. Everyone has to think about succession eventually

8:28Jon Fasman:Turkey's president Recep Tayyip Erdogan has no intention of leaving office anytime soon

8:33Rosie Blau:Pyotr Zalewski is our Turkey correspondent

8:36Jon Fasman:He has ruled Turkey since 2003, first as prime minister and then as president But that has not prevented some people in his camp from jockeying for position in case Erdogan decides to name a successor or cannot run in the coming elections.

8:55Rosie Blau:So I thought he was in for the long haul. Why are people talking about his successor now if he's got no intention of stepping down?

9:03Jon Fasman:Tayyip Erdogan has dismantled most checks on his power, but he has to contend with two things. One is elections and the other is term limits. Technically, he cannot run again after his current term expires. That is 2028. But he wants to remain in power. And many of the people around him, including his coalition partner, are desperate for him to do so. Now, there are two ways he could have a shot at another term and at least five more years in power. Constitutional changes or an early election, as long as that election is called by parliament. New constitution or constitutional changes are less likely.

9:44Jon Fasman:Erdogan would need the backing of at least 400 out of 600 members of parliament to push a new constitution without a referendum. And he does not have the numbers. Now, he could get 360 votes to put a new constitution to a referendum, but he risks losing such a referendum. The far more likely outcome is that Erdogan will ask parliament to call a snap election. presumably in late 2027.

10:12Rosie Blau:So what happens if he doesn't stand?

10:15Jon Fasman:Erdogan's health is something of a state secret in Turkey, but at 71 years old, he has visibly lost a step. And so if he doesn't stand in the next elections, he is expected to anoint a successor to run his Justice and Development Party and to run on his party's ticket. Now, the party itself has become something of a rubber stamp body and will probably have little to say on the subject. Publicly, justice and development leaders refuse to entertain a future without Erdogan at the helm. But behind closed doors, a struggle is taking shape, a struggle for Erdogan's ear and for his favor, and for pole position in a future race to succeed him.

10:59Rosie Blau:So who might succeed him?

11:01Jon Fasman:Four people are set to be in contention. The list occasionally changes. But these four include Erdogan's son-in-law, a former interior minister, the current foreign minister, and his youngest son, Bilal Erdogan. In a survey in December, about a third of Turks said they would like to see Foreign Minister Hakan Fidan in the role of justice and development party leader and Erdogan's successor. Bilal Erdogan came in at third place with just over 14%. Fidan, the foreign minister, has by far the best CV of the bunch. He has headed Turkey's intelligence agency for a decade. Before that, he was head of the country's development agency.

11:48Jon Fasman:And he has spent the last two years as Turkey's top diplomat. But Bilal, the sun, has become increasingly visible, both in media and in party politics. And there is speculation that he, in fact, is being groomed as Erdogan's prospective successor.

12:07Rosie Blau:So what do we know about Bilal beyond him being the president's son?

12:11Jon Fasman:He doesn't hold any public office, but he does have a spot on the board of a number of pro-government foundations. And he has been edging into the political limelight. He has made appearances at rallies for Palestine. He has been seen alongside his father at meetings with foreign dignitaries and foreign leaders. So all that has fueled speculation that he is being groomed to become Erdogan's successor. I spoke to some analysts who have held focus groups with Justice and Development Party voters. And the early verdict is that those voters oppose the idea of government as family business and a family or dynastic succession.