The recent rally in software stocks has proven short-lived. Lingering concerns about the disruptive potential of artificial intelligence (AI) have investors bracing for another wave of selling. The iShares Expanded Tech-Software Sector ETF (IGV), which tracks the software sector, surged 16% over three days earlier this month, driven by several strong earnings reports, briefly turning its year-to-date performance positive. However, that rally came to an abrupt halt on June 1st. The ETF has now declined for seven consecutive sessions, erasing all those gains. During this period, software has been the worst-performing sector within the S&P 500. The IGV is now down more than 12% for the year, compared to a 7.9% gain for the broader S&P 500 index.
Mike Bell, head of market strategy at RBC BlueBay Asset Management, stated, "Even after the weakness we've seen, we think there's further to go. The question isn't just whether software firms can maintain their old growth rates, but a more existential threat—that software products may become unnecessary if AI can do the work itself." Software stocks have faced intense scrutiny this year. Competitive pressure from startups like Anthropic and OpenAI has prompted a broad exodus of capital from the sector, compressing the earnings multiples for software stocks—a metric that was once among the highest in tech. On Tuesday, Anthropic's release of a new version of its Mythos AI model contributed to a 2.8% drop in the IGV, further stoking anxiety.
Bell noted, "When the range of uncertainty is this wide, traditional valuation metrics become less useful. It's fair to say the uncertainty is much higher than it has been in the past." Despite this, aggregated market data shows software company earnings this season have been encouraging: 90% of S&P 500 software firms have exceeded profit expectations, compared to 82% for the index overall. Analysts at Bank of America wrote in a June 8th client note that software companies presenting at the bank's Global Technology Conference earlier this month "collectively exhibited continued optimism." Standouts included Snowflake Inc., Datadog Inc., DigitalOcean Holdings Inc., and JFrog Inc., all of which reported robust results, demonstrating their solid positions within the software ecosystem. Cybersecurity has also been a bright spot this year.
Key Earnings Report Ahead
The next significant earnings report to watch will come from Adobe Inc., scheduled for release after the market closes on Thursday. This software maker for creative professionals is considered one of the companies most at risk from AI disruption, as AI tools have become highly proficient at image generation. Adobe's stock has fallen 32% year-to-date and has a poor track record following earnings—declining in nine out of the past eleven post-earnings sessions. Last quarter, long-time CEO Shantanu Narayen announced he would step down as the company faces questions about its ability to navigate the AI transition successfully. Following this sell-off, Adobe's valuation has become relatively cheap—trading at less than 10 times expected earnings, compared to an average of around 30 times over the past decade.
Nevertheless, investors remain hesitant to step in. Fiona Ker, a fund manager at Ruffer, which manages approximately $26 billion, said, "It's hard to imagine what Adobe's moat is, which means it looks like a replaceable company." She has begun building positions in some battered software names like Salesforce but is staying on the sidelines with Adobe.
Potential IPO Pressure
Expected initial public offerings (IPOs) from OpenAI and Anthropic could also pressure traditional software stocks. Anthropic, the developer of the Claude chatbot, could go public as soon as October, while OpenAI is reportedly targeting a listing around the fall. RBC BlueBay's Bell said, "These IPOs could have a direct impact as investors look to avoid losers in AI and overweight those they think will do well. These are clearly potential AI winners people would want to own."
Finding Value Amid Uncertainty
Ruffer's Ker believes investors can have more confidence in the outlook for companies with large enterprise clients, where switching suppliers might involve legal or compliance hurdles. She stated, "The frontier of what AI can do is still moving, and if you want to extrapolate what sustainable growth looks like from that, it's a big problem. But when I look at these software stocks, I see decent free cash flow yields and multiples below the market average. It's an attractive opportunity set, and I think you're being paid for that uncertainty."
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