Software stocks have crashed, and no one dares to "catch the falling knife."

The U.S. software sector suffered its worst sell-off since 2022 on Wednesday, but the "bottom-fishing money" that usually rushes in during tech stock plunges was collectively absent.

After the S&P 500 Software & Services Index plunged nearly 4% on Tuesday, it fell another 1% on Wednesday, marking the sixth consecutive trading day of declines. Unlike past market pullbacks, this sell-off failed to attract any noticeable bargain hunting.

Options traders are also steering clear of software stocks, with trading flows showing investors increasing defensive positions rather than seeking buying opportunities. Even Microsoft, long considered a safe haven, was not spared; short sellers are aggressively increasing their bets.

This sell-off in the software sector is the worst since 2022. Back then, rising interest rates hit software stocks hard, but sentiment has now shifted from valuation concerns to deeper anxiety about AI technology potentially disrupting traditional software business models. The collective avoidance of bottom-fishing by investors suggests the market's view of the software sector may be shifting from a short-term correction to a structural revaluation.

Bottom-fishing money missing en masse

Steve Sosnick, Chief Strategist at Interactive Brokers, said the firm’s clients showed a marked lack of enthusiasm for bottom-fishing in software stocks, in sharp contrast to precious metals and semiconductors. "Overall, our clients are far less willing to bottom-fish in software stocks than precious metals and semiconductors," he said. "There may be clients buying software stocks, but it's certainly not the focus of their trading activity."

This cautious attitude is even more obvious in the options market. Chris Murphy, co-head of derivatives strategy at Susquehanna Financial, pointed out that the software sector remains under sustained pressure, and options flows are primarily defensive.

In the options trading of the iShares Expanded Tech-Software Sector ETF and the ARK Innovation ETF, traders are increasing downside exposure rather than buying the dip. On Wednesday, IGV fell 3%, and ARKK ETF plunged nearly 7%. Murphy said the overall tone for the software sector remains defensive.

Microsoft becomes the sole bright spot, but short sellers are swarming

Sosnick noted that Microsoft is one of the few exceptions in the sector. Although the company is not purely a software firm, it still attracts some buyers. Since its earnings report was released on January 28, Microsoft’s share price has fallen about 15% cumulatively, but it rose about 1% on Wednesday.

However, even Microsoft could not escape the hunt of short sellers. Leon Gross, research analyst at S3 Partners, said short sellers were encouraged by the sector's sharp decline and are increasing short positions despite continued price pressure.

"Historically, Microsoft has behaved like a reversal stock, with short sellers covering on the way down. But now, its trading pattern resembles a momentum-driven distressed stock, with short sellers increasing positions as the share price weakens," Gross said. Data shows Microsoft’s short interest increased by about 20% over the past week.

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