The software sector's short-lived rebound has ended, with the persistent threat of AI disruption continuing to weigh on valuations.
According to reports, the iShares Expanded Tech-Software Sector ETF (IGV), which tracks software stocks, surged 16% over three days earlier this month, driven by several strong earnings reports, briefly turning its year-to-date performance positive. However, the rally ended on June 1st, followed by seven consecutive days of declines, completely erasing all those gains. The IGV is now down over 12% for the year, compared to a 7.9% gain for the S&P 500, making the software sector the worst-performing industry.
Market concerns that AI will upend traditional software business models continue to suppress valuations. The announcement of a new AI model, Mythos, by Anthropic on Tuesday further intensified this sentiment, causing the IGV to drop 2.8% that day. Mike Bell, Head of Strategy at RBC BlueBay Asset Management, stated, "Even after this move, there is scope for further downside."
The core pressure on software stocks stems from the rise of AI startups like Anthropic and OpenAI, which has shaken investor confidence in the moats of traditional software companies, persistently compressing the sector's valuation multiples that were once ahead of the broader technology industry. Bell noted, "It's not just about whether they can maintain growth, it's an existential threat—if the AI can do the work itself, the product may not be needed at all."
Earnings Beat Expectations but Mask Structural Divergence; Adobe's Report Looms
Despite the overall pressure on the software sector, the latest earnings season data is not entirely bleak. Data compiled shows that 90% of software companies in the S&P 500 exceeded profit expectations, higher than the 82% beat rate for the broader index. A Bank of America report on June 8th also noted that software companies participating in the bank's global technology conference earlier this month displayed "consistent optimism across industries."
On an individual stock level, Snowflake Inc, Datadog Inc, DigitalOcean Holdings Inc, and JFrog Ltd all reported strong results, demonstrating their solid positions within the software ecosystem. The cybersecurity field has also performed notably well this year, standing out as one of the few bright spots within the sector.
Against this backdrop of generally positive earnings, the most closely watched report this week comes from Adobe Inc, scheduled for release after the market closes on Thursday. As a software giant serving creative professionals, the company is seen as one of the most at-risk from the disruption of AI image generation technology.
Adobe shares have fallen 32% year-to-date, and its post-earnings track record is weak—its stock declined in 9 out of the last 11 earnings announcements. Last quarter, the announcement that long-time CEO Shantanu Narayen will step down further fueled market concerns about the company's ability to successfully navigate the AI transition.
Impending AI IPOs Threaten to Divert Capital from Traditional Software
The potential IPO plans for OpenAI and Anthropic are seen as another pressure point for traditional software stocks. Reports suggest Anthropic could go public as early as October this year, with OpenAI also targeting a potential listing this fall.
RBC BlueBay's Mike Bell believes these IPOs have a direct impact on traditional software stocks: "Investors want to avoid losers in AI and overweight the likely winners. These are clearly potential AI winners that people can allocate to."
In contrast, Fiona Ker, a portfolio manager at Ruffer, holds a relatively optimistic view on some software companies, particularly those with large enterprise clients that face legal or compliance hurdles to switching vendors easily.
She stated, "The capability frontier of AI is moving, which makes it incredibly difficult to predict sustainable growth. But from a valuation perspective, these companies have decent free cash flow yields and below-market multiples, making it an interesting opportunity set. I think the uncertainty is priced in at this point."
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