US software stocks tumble sparks concerns that AI trade is reshaping markets

By Saqib Iqbal Ahmed and Lewis Krauskopf

NEW YORK, Feb 9 (Reuters) - The software and services industry's recent plunge has ignited fears that the artificial intelligence boom may be reshaping markets in unexpected ways, raising questions about whether a rotation out of technology stocks signals trouble ahead for the AI trade.

Financial markets, juiced for months with investor enthusiasm about the artificial intelligence trade, got a rude awakening last week as software stocks around the globe sank on worries that fast-advancing AI tools could upend the industry.

While a rebound in the broader market helped soothe nerves on Friday, the outlook for U.S. software stocks, at the epicenter of the selloff, remained murky. Despite a 2% rebound on Friday, options market participants remained on high alert for further pain.

The selloff, which crossed continents knocking stocks from Europe to Asia, was triggered by a new legal tool from Anthropic's Claude large language model that raised existential questions about traditional software business models.

Investors are questioning whether the earnings-compounding nature of software companies would get disrupted, with strategists noting a broader rotation into value and cyclical-oriented sectors such as consumer staples, energy and industrials.

SOFTWARE SLUMP

Software and services stocks' underperformance against the S&P 500 has reached near-record proportions, with the sector lagging the benchmark by nearly 24 percentage points over the past three months, nearly the worst such gap in data going back three decades.

The downturn marks a stark reversal for the industry group that overall put up outsized gains for much of the post-pandemic era, when investors bet on digital transformation and cloud computing.

The current selloff rivals only a handful of periods since 1995, including the dot-com crash of 2000-2001, when the spread plunged below negative 25.

To be sure, historically, such extreme readings have sometimes preceded either capitulation selling or marked attractive entry points for contrarian investors, though the 2000-2001 period showed underperformance could persist for extended stretches.

SOFTWARE GLITCH

For now, the selloff has left many U.S. software stocks smarting from eye-watering losses since the S&P technology sector peaked in late October.

Oracle ORCL.N is the loss leader, having shed nearly 50%, from October 29 to February 5, while ServiceNow NOW.N and AppLovin APP.O each tumbled more than 40%.

Gartner IT.N, Palantir PLTR.O, Intuit INTU.O, Datadog DDOG.O, and Workday WDAY.O were also swept away in the selloff.

TURNING AWAY FROM TECH

The swoon in software stocks comes amid a broader market shift away from technology.

The heavyweight tech sector .SPLRCT has stumbled since its late-October peak, sinking some 10% over that time as of Friday morning trading.

Other areas of the market have thrived over that period.

The energy .SPNY, materials .SPLRCM, consumer staples .SPLRCS and industrials .SPLRCI sectors all have climbed at least 10% over that time, during which eight of the 11 S&P 500 sectors have posted gains.

Yet the overall S&P 500 .SPX is little changed over that time. With the tech sector still accounting for nearly one-third of the weight of the benchmark index, investors are concerned that the market will struggle to make headway if tech continues to struggle.

On Friday, the Dow Jones Industrial Average rose above 50,000 points for the first time, helped by a rally in shares of Nvidia.

VOLATILE OUTLOOK

While selling pressure on software stocks eased on Friday, with the industry index rising, traders in the options market were hesitant to dial back expectations for more near-term stock gyrations.

For the $6 billion iShares Expanded Tech-Software Sector ETF IGV.P, 30-day implied volatility - a gauge of how much traders expect the shares to swing in the near term - was 41%, barely down from the 10-month high of 45% touched on Thursday.

The elevated volatility gauge suggests traders are not quite sure whether the worst of the selloff is over.

Meanwhile short sellers, who aim to sell borrowed shares to buy them back later at a lower price, were poised to capitalize on further share price declines. Through Thursday, the IGV ETF's short interest - or the number of shares short as a percentage of the free float - stood at 19%, close to the highest ever, according to data and analytics company Ortex Technologies.