US stocks rocked by AI panic! Anthropic's new tool triggers software stock sell-off, Reuters plunges over 20% intraday.

The launch of new automation tools by AI startup Anthropic on Tuesday triggered panic selling in software stocks, causing all three major U.S. stock indexes to retreat. In intraday trading, the S&P 500 fell more than 1.6%, the Nasdaq Composite dropped around 2.4%, the Nasdaq 100 declined over 2%, and the Dow Jones Industrial Average plunged nearly 1.2% at its deepest. This round of sell-off has broken the rebound momentum from Monday, with the Nasdaq and S&P pulling back from recent highs.

During Tuesday’s sell-off, legal software and data services firms bore the brunt. Thomson Reuters (TRI) at one point fell 20.7% intraday, Legalzoom.com (LZ) dropped more than 20%, London Stock Exchange Group’s UK shares closed down 12.8%, its U.S. OTC shares fell more than 10% intraday, and CS Disco (LAW) also tumbled more than 10% intraday.

The iShares Expanded Tech-Software Sector ETF (IGV), which tracks the technology software sector, hit a daily low with an intraday drop of 5.6%. By Tuesday, it had fallen for six consecutive trading days, with a cumulative six-day drop of over 14%. In January, this ETF fell about 15%, marking the worst single-month performance since 2008.

Investors are worried that the core businesses of software companies now face the threat of AI technology replacement. In a research report, Morgan Stanley analysts led by Toni Kaplan pointed out that Anthropic’s new functions for the legal field have increased industry competition: “We see this as a sign of intensifying competition, which may pose negative impacts.”

Panic spread to software business development companies (BDCs) such as Blue Owl Capital Corp., with shares dropping amid mounting concerns about firms with significant exposure to the software industry. The media indicated that such industry turmoil has triggered credit market shocks globally, leading to lower prices last week in the syndicated loan market for widely held software company debt.

Software stocks have also underperformed the broader tech sector during earnings season. Media-compiled data shows that among S&P 500 software companies that have reported earnings so far, only 71% surpassed Wall Street’s revenue expectations, compared to 85% for the overall tech sector.

Stephen Yiu, Chief Investment Officer of Blue Whale Growth Fund, said, “This year will be pivotal in determining which companies are AI winners and which are victims, and the core skill is to avoid losers. Taking the opposite side against AI before the dust settles is a risky move.”

Software Stocks Face SaaS Apocalypse-style Sell-off

Wall Street’s pessimism on software stocks has evolved from caution to doomsday panic. Jeffrey Favuzza, a trader from Jefferies’ equity trading team, said, “We call it ‘SaaSpocalypse’, or the apocalypse of Software as a Service (SaaS) stocks. The trading approach is a ‘get me out’ style of selling.”

Anxiety escalated further on Tuesday after AI startup Anthropic released productivity tools for in-house corporate lawyers. These tools triggered sharp declines in shares of legal software and publishing companies, with selling pressure sweeping across the sector.

This anxiety has been brewing for months. In January, Anthropic launched the Claude Cowork tool, greatly intensifying fears of industry disruption. Last week, video game stocks were also swept into the sell-off after Alphabet started rolling out Project Genie, which lets users create immersive virtual worlds via text or image prompts. The S&P North American Software Index has fallen for three consecutive weeks, plunging 15% in January, the largest single-month drop since October 2008.

Favuzza said, “I asked clients, ‘Where’s your breaking point?’ Even as capitulation-level selling occurred, I haven’t heard any clear answers. People are just selling everything and don’t care about the price.”

This anxiety has also reached the private equity sector. The media revealed on Tuesday that firms including Arcmont Asset Management and Hayfin Capital Management are hiring advisors to examine which businesses in their portfolios could be affected. Apollo plans to nearly halve its direct loan fund’s software exposure by 2025, sharply down from about 20% at the start of the year.

Anthropic’s Unique Edge Sparks Market Worries

Anthropic is one of many AI startups developing tools for the legal industry, but its unique status has intensified market worry. Long before Anthropic’s plugin launch, startups like Legora and Harvey AI were already flooding the legal sector with tools claiming to relieve lawyers from repetitive tasks. For over two years, investors have poured capital into AI products for the legal industry, with Harvey AI valued at $5 billion in June 2023 and Legora raising funds at a $1.8 billion valuation in October 2023.

What sets Anthropic apart is its self-built models, which can be customized to meet industry-specific needs. As a major model developer, its status in the AI ecosystem gives it a unique advantage in disrupting both traditional legal news and data services, as well as the new legal AI upstarts. Companies like Legora depend on underlying models made by Anthropic and others.

On its plugin website, Anthropic’s legal tools can automate tasks such as contract review and legal briefings. The site states: “All outputs should be reviewed by a licensed attorney.”

Other product launches, including Project Genie by Alphabet last week, have also amplified the sell-off. “This year will define which enterprises are AI winners and losers, and the key skill is to avoid losers,” Stephen Yiu said.

Microsoft’s Decline Highlights Industry Challenges

Even software giants cannot escape AI skepticism. Microsoft posted solid earnings last week, but investors focused on slowing cloud sales growth and reassessed its AI spending, sending its shares down 10% last Thursday and over 3% intraday on Tuesday, marking four straight days of declines.

January 2024 was Microsoft’s worst-performing month in more than a decade. At the same time, earnings reports from ServiceNow and SAP gave investors more reasons to remain cautious about the software sector’s growth outlook.

Thomas Shipp, head of equity research at LPL Financial, which manages $2.4 trillion in brokerage and advisory assets, said, “AI brings fears of heightened competition, greater pricing pressure, and shallower competitive moats, meaning it’s easier to be displaced by AI. The range of potential growth outcomes gets wider, making it harder to assign a fair value or judge what’s cheap.”

These AI-related concerns prompted Piper Sandler to downgrade software firms such as Adobe, Freshworks, and Vertex on Monday. Analyst Billy Fitzsimmons wrote: “We worry that seat compression and the vibe coding narrative could cap valuation multiples.” Vibe coding refers to software development written by AI.

Even though all software stocks surpassed earnings expectations this quarter, it means little against long-term concerns. According to Bloomberg-compiled data, thus far in this earnings season, only 67% of S&P 500 software companies have beat revenue expectations, while 83% of all tech firms did.

Palantir Emerges as a Rare Bright Spot

Despite the broad market decline, most S&P 500 component stocks still rose. Economic bellwether FedEx continued its record rally, while Walmart’s market cap surpassed $1 trillion.

Steve Sosnick, Chief Strategist at Interactive Brokers, said that the U.S. equity market “is undergoing a sector rotation. The tricky question is whether this is a benign reallocation of exposure or a signal of some underlying instability.”

Within AI concept stocks, data analytics firm Palantir Technologies surged against the trend. The company reported after the close on Monday that fourth-quarter revenue rose 70%, beating Wall Street expectations, and issued much higher-than-expected annual guidance for this year. Its shares gained nearly 7% on Tuesday.

Some professional investors see opportunities in the software sell-off. The European open-ended fund Sycomore Sustainable Tech, which has outperformed 99% of peers in the last three years, bought Microsoft shares during the downturn, anticipating the company will eventually become an AI winner.

Microsoft’s valuation is now quite attractive, with a forward P/E ratio under 23 times, the lowest in nearly three years. Technically speaking, its 14-day relative strength index is in oversold territory. More broadly, the software index’s valuation multiples are at multi-year lows, and its RSI also shows oversold conditions.

BTIG chief market technician Jonathan Krinsky wrote in a client report last week that the software sector “may be oversold enough to rebound.” However, he added, “Repairing and building new foundations will take a long time,” and “given the real acceleration in relative strength deterioration in Q4 last year, we are not bullish on software.”

The core issue for investors is distinguishing AI winners from losers. Clearly, some companies will thrive, meaning their shares are essentially being sold at a discount after the recent plunge. But it may be too soon to judge who the winners will be.

Jefferies’ Favuzza said:

“The bearish view is that, going forward, the software industry could be the next print media or department store in terms of outlook. Market sentiment is so extremely biased toward selling everything that it suggests there will be some highly attractive investment opportunities. We’re all waiting for growth to reaccelerate, and when I look ahead to 2026 or 2027 data, it’s hard to see further upside. If even Microsoft is struggling, for companies more likely to be hit by disruptive tech or without such market dominance, things could be significantly worse.”

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