Software: Reports of its death have been greatly exaggerated.
Written by Julian Wheeler – Partner and US Equity Specialist
Credit to Mark Twain for yet again providing me with a well-known (although always misquoted) title.
Long before the Middle East conflict erupted, the dominant theme within US equities for the last six months has been the breakneck descent in software valuations. Since a peak last October, the sector has been on a ‘closing down’ sale. From Microsoft downwards, stocks of household names in this sector have declined by at least one third and those that are judged to be particularly weak have been cut in half. So, what has gone wrong?
With every rapid advancement of a new and improved AI Model, the narrative took hold that software giants such as Adobe, Intuit, Salesforce etc etc would instantly be rendered helpless, their competitive moats filled in overnight by the magic cement of ‘vibe coding’. With the help of these tools, almost anyone was able to perform the function of a software engineer and thus what were once perceived as fortress stocks, highly valued thanks to their recurring revenue streams from SaaS, have been decimated in expectation that there will shortly be a new, free-for-all, DIY software alternative.
The selling reached a crescendo around the time of a publication of a research report that suggested that the whole software ecosystem (and pretty much all white-collar employment as we know it) was finished. At the same time, the credit default swaps of Oracle – the most leveraged of all to this incredible spending binge – reached a peak higher than both dotcom and GFC climaxes. In the last week it has been one of the best performers in the market recovery.
Has the market got it right to squish software stocks? Well, some perhaps, but “I’ll take the ‘Don’ts” on that one for the whole sector. (No one plays Craps in the UK, but my American readers will understand). It means I’ll bet against the player with the dice, or the sellers of software in this case. It was thirty years ago this year that Bill Gates made this famous observation: markets and investors overestimated the speed of technological change in the one-to-two-year timeframe but also underestimated its impact over ten. That is what is happening here; while the change being ushered in by the AI revolution will be real and unstoppable over the next decade, it is just not going to happen as fast as the stock market is pricing it into the shares of both winners and losers this year.
The first reason is because the very rush to bring on AI is being too successful too quickly. It means that we have reached the constraints of the physical supply capacity to meet what is an undeniably insatiable demand. It’s not just about power and data centre space. One of the hottest properties right now (judging by the share price rises anyway) is optical network components; one of the leading suppliers, Lumentum Holdings inc, just announced that within six months they will be sold out: not for this year, or next but to the end of 2028. All that is doing is rapidly driving up the prices of ‘tokens’ (what you buy to run your machines) which means the supposed efficiency gain from replacing humans by machines is entirely eroded and furthermore, if you can’t get the ‘kit’ then how do all these upstarts do all of that ‘disrupting’ of those software incumbents anyway!
The second is rather less obvious because this is my own supposition rather than fact, for the moment at least. It is that the new Mythos model from Anthropic has genuinely frightened the establishment. When a meeting is convened between the Chairman of the Fed, US Treasury Secretary and all the CEOs of the US banking system within a week of the announcement, then something has changed. If a machine can spot holes in the security of the whole financial system making it akin to a Swiss cheese, then I suspect some brakes may be applied by regulators around further AI deployment, or at least a moratorium dictating a pause.
What if, just suppose, on this next set of earnings calls, the “hyperscalers” (Alphabet, Amazon, Meta, Microsoft) do NOT increase their Capex plans? I am not saying they will cancel orders, or abandon already announced projects, but perhaps they might just not raise numbers above their existing guidance. The last time there was a ‘non increase’ like that was all the way back in q1 of 2023, which was just before the astounding impact of Chat GPT tsunami goosed the demand for compute power. For the last three years since then, their cashflow has more or less just been transferred into the coffers of Nvidia and their ilk, leading to an outperformance of the Semiconductor index versus its Software equivalent of almost 300%. But what if we have reached the peak of growth in capex, for the simple reason that there is nothing more to buy for a while, however much you might want it. Time to reverse that trend?
For more background on our U.S. market views, visit the Over the Pond archive.
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