The AI Spending Spree: Déjà Vu for Investors?
On February 8th, during the Super Bowl, viewers were introduced to an advertisement for Claude, an artificial-intelligence chatbot. For investors with long memories, this moment evoked an unsettling sense of déjà vu. The 2000 Super Bowl became legendary in market folklore as the peak of internet-stock mania, featuring 17 dotcom firms paying millions for 30-second ad slots. Within weeks, share prices plummeted into a brutal bear market.
Today, confidence in the emerging technology of artificial intelligence is already wavering, even as companies prepare to invest staggering sums. Over the past two weeks, Alphabet, Amazon, Meta, and Microsoft announced plans to spend a combined $660 billion on AI in the coming year. Investors who once cheered such ambitions are now growing cautious. Each company's stock price has declined following its announcement, with Meta's initially surging only to tumble below previous levels, and Microsoft's dropping by 18%.
Why Markets Are Jittery
It's no surprise that markets feel uneasy. Stock prices, particularly in America but increasingly globally, are expensive relative to underlying earnings. When valuations are high, expected returns are low, and shareholders face greater risks from a potential crash. The challenge lies in identifying which assets might offer a safe haven.
Gold, the traditional refuge for investors, has experienced wild price swings in recent weeks. Bitcoin, a digital alternative, has also shown volatility. As investors seek ways to hedge equity risk, viable opportunities appear scarce.
The Dilemma of Selling Stocks
The most straightforward method to protect against a stock market crash is to sell stocks. However, for most professional investors, this isn't feasible. While some hedge funds have flexible portfolios, many money managers operate under strict constraints. For instance, an equity fund is expected to invest in equities; holding cash could lead to client withdrawals, as investors can manage cash independently without paying fees.
Individual investors face no such restrictions, but selling stocks due to high valuations can be a flawed strategy. During the dotcom bubble, the NASDAQ index's valuation relative to earnings soared to multiples of today's levels. From 1995 to its peak in March 2000, the index corrected by 10% or more over a dozen times, yet it ultimately rose nearly 12-fold. Even after the subsequent plunge, investors who bought in 1995 and held on would have doubled their money.
Hedging Strategies: Lessons from the Dotcom Crash
An effective hedging strategy should minimize returns suppression during upturns while cushioning losses during downturns. Analyzing the dotcom crash reveals three primary categories of hedging candidates: the classic stocks-bonds split, exotic derivative strategies, and alternative equity diversifiers.
Bonds as a Hedge: A Historical Perspective
For asset allocators with flexibility, combining stocks with bonds proved effective in the late 1990s. As inflation from the 1970s and 1980s receded, borrowing costs for rich-world governments declined, benefiting bondholders through inverse price-yield movements. From early 1995 to the NASDAQ's March 2000 peak, Bloomberg's American Treasuries index rose by nearly 50%. When share prices fell, central banks cut interest rates, and bondholders gained from further yield drops, with the index rising another 30% during the NASDAQ's decline.
However, government bonds may no longer be as reliable for hedging equity risk. In the 2022 bear market, both asset classes suffered as inflation surged and interest rates climbed. Today, resurgent inflation and hawkish central bank responses are top concerns for ending bull markets, potentially causing stocks and bonds to fall together. Events like the "Liberation Day" tariffs in April last year briefly triggered simultaneous drops in Treasuries and stocks due to policy uncertainties, highlighting risks to bonds' safe-haven status.
Derivative Strategies: The Role of Options
A second category involves derivative contracts like options, used by hedge funds and increasingly available to retail investors. Overlaying a stock portfolio with options allows profit harvesting during rises and loss limitation during downturns.
For example, a "put" option grants the right to sell a stock at a pre-agreed strike price on a future date, capping losses. Setting a strike at 90% of the current price limits losses to 10%. Currently, a put option on the S&P 500 limiting losses to 10% over a year costs 3.6% of the protected amount, meaning investors sacrifice 3.6 percentage points of returns for crash protection.
Yet, hedge performance depends heavily on strike price and expiration date. Goldman Sachs analysts compared strategies from 1996 to 2002: one-year options limiting losses to 10% and one-month options limiting losses to 4%. Both offered protection during the dotcom burst, but costs accumulated. The one-year options yielded similar annualized returns as unhedged portfolios with less volatility, while one-month options resulted in substantially worse returns despite the crash.
Alternative Diversifiers: The Equity Hedge
The most effective strategies identified by Goldman Sachs fell into the third category: combining stocks with non-bond diversifiers. Notably, filtered stock baskets like the S&P 500 "low volatility" subindex, comprising the 100 least volatile stocks, performed well. A 50/50 split with the S&P 500 from 1996 to 2002 generated nearly twice the annualized excess returns over cash compared to the S&P 500 alone.
Similar results came from splits with the S&P 500 "dividend aristocrats" index, which includes companies with 25 years of dividend increases, and "quality" stocks characterized by high returns on equity, stable earnings, and low net debt.
Conclusion: The Best Hedge May Be More Stocks
In today's market, the notion that the best way to hedge equity risk is with equities might seem counterintuitive. Yet, given the limitations of bonds and the costs of derivatives, it could represent the most viable option for shareholders. As AI investments soar and memories of past bubbles linger, investors must carefully weigh their hedging strategies to navigate potential volatility ahead.
