AI shock could broaden stock rally

January 29, 2025 (MLN): A development in the field of artificial intelligence that staggered asset prices could help set the stage for broader stock strength beyond the narrow group of technology shares that have propelled the market higher.

Tech stocks, led by megacap companies, have been the driving force of the current bull market.

The S&P 500 tech sector has gained some 90% in the past two years, nearly doubling the gain for the overall benchmark index.

But the sector stumbled badly on Monday as investors factored in implications from the low-cost Chinese AI model, with shares of high-profile tech names such as Nvidia, Broadcom, and Oracle getting pummeled.

Even as the group recouped some of those losses on Tuesday, investors were considering the changing character of the market, especially as they anticipate broader earnings improvement this year.

"It's a catalyst for more balanced market leadership," said Keith Lerner, co-chief investment officer at Truist Advisory Services, as Reuters reported.

"Ultimately, that's a positive because that means there are other areas for investors to make money."

Market leadership has been particularly concentrated in a group of tech and tech-related megacap stocks known as the Magnificent Seven: Nvidia, Apple, Microsoft, Google parent Alphabet, Amazon, Facebook owner Meta Platforms, and Tesla.

Those stocks combined accounted for 55% of the S&P 500's total return since the end of 2022 as of Monday, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

This year, however, the Magnificent Seven overall had been a negative influence on S&P 500 performance as of Monday.

Signs of a nascent rotation were evident amid the DeepSeek fallout. Even as the S&P 500 fell 1.5% on Monday, dragged down by stocks that carry heavy weights in the index, about 70% of S&P 500 constituents rose, according to Barclays strategists.

"Sector performance differed from similar risk-off days of the past few years, showing a notable 'broadening' tilt away from tech," the Barclays strategists said in a note.

The S&P 500 growth index, which is heavily populated by tech stocks, dropped about 3.6% on Monday, while the counterpart value stock index rose nearly 1%.

That was the biggest one-day percentage point advantage for value stocks over growth in the roughly 30 years of data on record, according to LSEG data.

While Wall Street may take time to understand the implications of DeepSeek, Monday's price action was a wake-up call for many who believed these stocks were invincible.

The result may be a shift of investments away from that sector and into other areas of the market, said Peter Tuz, president of Chase Investment Counsel.

In the options market, while there was some element of dip buying, traders appeared interested in broadening their horizons beyond the Magnificent Seven stocks.

"I think people are using this as an opportunity to start to check out other sectors," said Chris Murphy, co-head of derivative strategy at Susquehanna Financial Group.

Many investors already had been expecting stock strength to spread beyond tech and the Magnificent Seven, stemming from earnings trends.

While Magnificent Seven earnings growth far exceeded performance for the rest of the S&P 500 over the past year, that gap is expected to close.

In 2025, Magnificent Seven earnings are expected to rise 19% against a 12.3% increase for the rest of the index, said Tajinder Dhillon, senior research analyst at LSEG.

A flood of quarterly earnings reports is due over the next few weeks, including Microsoft, Meta, and Tesla on Wednesday and Apple on Thursday.

"That's important to watch these earnings come in," said Don Nesbitt, senior portfolio manager at F/m Investments.

"You have some signals that, yes, things could be broadening out here."

Plenty of investors remain bullish on tech and even some who expect a market broadening say the group can continue to do well. Indeed, the tech sector bounced back on Tuesday, rising over 3%, but was still lower than before the DeepSeek news rippled through markets.

Robert Pavlik, senior portfolio manager at Dakota Wealth Management, said DeepSeek could lead to a rotation to companies benefiting from access to lower-cost AI, with software stocks among the potential beneficiaries.

He manages portfolios that include software stocks such as Microsoft, ServiceNow, and Salesforce.

Monday's market action gave a "jolt" to a potential market broadening, said Walter Todd, chief investment officer at Greenwood Capital.

But given how long tech has held the market reins, Todd said, "it's going to take some time for that to turn."

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