Software stocks got crushed. Did they have it coming?

0:05Pushkin.

0:08Rob Armstrong: Remember that whole thing in February? Markets got spooked by this sudden moment of dread that AI would demolish everything in its path, starting with software companies and ending in our livelihoods. It wiped a trillion dollars off the value of software stocks, And those stocks are still down as a group about 20 % from where they were a year ago, even when the rest of the market is up a fair amount. And look, it remains possible that AI will kill all the jobs and then, I don't know, kill all the humans. But here at Unhedged, we are humble markets people, ill-equipped to tackle such grand moral and social issues.

0:48Rob Armstrong: What we want to figure out is whether that market shakeout was overdone or a warning of things to come. This is Unhedged, the markets and finance podcast from the Financial Times. I'm Pushkin. I'm Katie Martin, a markets columnist at the FT in London, where the producers have tried to ban me from talking about the weather, but God, it is so hot, like insanely hot. Joining me, joining me down the line from New York City. We just can't keep him away from the show. And if we did, Donald Trump would call FIFA up and make us take him back. It's Rob Armstrong off of the unhedged newsletter.

1:29Katie Martin: Katie, it's just a law of nature that British people must talk about the weather. trying to stop them is like trying to travel at greater than the speed of light or have gravity go the other direction. I don't know why the producers even ask you to not talk about the weather. There's nothing to be done about it.

1:48Rob Armstrong: But the other thing that we are like genetically programmed to talk about is the football.

1:53Katie Martin: Yes.

1:53Rob Armstrong: Your boys took a hell of a beating of Belgium last night.

1:57Katie Martin: But if they'd won, there would have been this horrible asterisk next to it after the president tried. you know, reverse the red card thingy. And look, I mean, there is a kind of aspect of this, which is like FIFA corrupt. Stop the presses, you know, but, you know, still it's not a good look and that we would have had some explaining to do. Anyway, moving on.

2:24Rob Armstrong: Yes. Matter at hand is like AI and tech and which bits of the market is eating first and what that is all telling us. Why don't you take us back to that weird period in February when everything went a bit skewy?

2:41Katie Martin: Well, we got that report from a research firm that sketched in possibly incoherent terms how AI might cause the economy as we now understand it to collapse and everything would be different now. Was it Citrini? Is that the name of the firm?

3:03Rob Armstrong: Yeah, Citrini Research.

3:04Katie Martin: Anyway, what that report showed was that the market was searching about for a reason to panic about AI and panic it did. And a lot of stocks got punched in the face, but the stocks that got punched in the face hardest then and kind of throughout the whole AI excitement are companies that make software, basically big corporate software companies. And the picture is you're going to be able to make your own software by vibe coding and you won't need to buy software from Adobe, Intuit, Workday, ServiceNow, Salesforce, Oracle or the rest of the lads.

3:46Rob Armstrong: Now, it wasn't just the Citrini research paper, though, was it? it was also the Anthropic-launched Claude Cowork, which is this sort of AI coding thing. And people started using it, and they were like, holy smokes, this thing is good. It massively speeds up my coding time. This is a total game changer. I mean, I really don't know anything about coding. I'm going to just put my hands up here and say no clue. But people who do have a clue are like, whoa, this thing is the real deal. So suddenly, as you say, we had this big hit to software stocks. So in the US, the S &P 500 software and services index, the stocks index, covers this sector, is still down 21 % from a year ago.

4:32Katie Martin: And some big constituents of that index are down a lot more than that.

4:35Rob Armstrong: Yeah. And that's hugely out of whack with the rest of the market. So the rest of the market is saying, yay, AI, it's also fantastic. This is going to, you know, pay for our retirements. But there's this like subsector that's like bleeding out. So we did a bit of work on this on the on the newsletter this week, didn't we? Just trying to figure out, have some babies been thrown out with the bathwater here? Or does this actually make sense?

4:59Katie Martin: I just want to shout out to the person who did the work. Dara McFadden, your selfless understudy in the London office, who you wouldn't let come on the podcast because you have him slaving over a hot keyboard, writing something else.

5:15Rob Armstrong: I need him to keep working hard so that I can...

5:16Katie Martin: While you flounce around making podcasts, he's out analyzing things.

5:22Rob Armstrong: Yes, I'm like AI, taking all the credit.

5:27Katie Martin: He is your AI. Dara basically is our AI. We just talk to him and he creates things for us. Anyway, we did a bit of work and it's pretty remarkable. I just reeled off that list of names. And those are kind of the biggest companies that sell software as a service packages to companies. And that's why that's they call that SAS, the business model where the business pays a subscription every month and they have access to this software package that helps them do businessy things. As such, this event has been called the SASpocalypse.

6:06Rob Armstrong: It's like a really bad name. I kind of like it. sasspocalypse it's a no from me anyway anyway it's the sasspocalypse if you look at these

6:15Katie Martin: companies the big business software companies like adobe intuit workday service now salesforce oracle they are trading at 40 maybe even a third of their recent highs a lot of them can be snapped up at p e ratios you would associate with like banks or highly cyclical businesses or businesses that are not doing well. Yet, they're still growing businesses. The AI bomb has not yet landed on these companies. Their businesses are still growing as they have been growing for years. It's just a vision of the future, not what's happening in the present that has caused these huge moves in these stocks.

7:00Rob Armstrong: But that's what markets are supposed to do, right? They're supposed to guess what's going to happen next and not reflect what's just happening today. But for example, one of the the reasons why some people think this is all massively overdone is that if you're a big business right you make widgets whatever and you have like software in the building that helps you dispatch those widgets and you use it to order new bits to make your widgets and you use it to communicate with your bank so that the people who work making the widgets all get paid yes you you don't just like switch that off and plug your business into Claude no right this that's just Ridiculous.

7:39Katie Martin: You certainly do not.

7:40Rob Armstrong: If you do, you shouldn't do that.

7:42Katie Martin: And it is an epic pain in the neck to get your business running on one of these software platforms. So like, okay, we're going to load up all of our databases onto Oracle. You are then an Oracle company. And the nightmare of switching all the people who know how to run the Oracle system and all the data that's in the Oracle system and all of that into a new system, is just a nightmare. I mean, I remember writing a piece about database software probably 20 years ago now. And, you know, new kinds of databases were coming out more flexible, you know, trickier databases, basically, than the standard kind of spreadsheet-y ones, you know.

8:30Katie Martin: And everybody was like, oh, yeah, told me. Oh, yeah, Oracle's dead. You know, they're the thing of the past. you know what i mean and boy did that not happen you know so is your hunch that some of these

8:44Rob Armstrong: individual stocks and we're not in the business of giving stock tips or financial advice but it's your sense that some we are in that business we're just really bad at it katie yeah but do you think some of them have been punished like too much like does this not make

8:58Katie Martin: sense yes i mean the one i would call out i mean i think i mean dara made this point really clear If you have a software platform that holds your business's mission critical information, and most especially, it's how your business's information interacts with the regulatory mechanisms that dominate your industry. You know what I mean? This is how you make your reports. This is how you tell your compliance officer that this is going on. This is how you tell the SEC that this, you know, all of this stuff. You're just not going to rip that stuff out anytime soon.

9:40Rob Armstrong: So why don't the stocks just recover then?

9:42Katie Martin: That's a great question. I mean, I think it's you said just now, Katie, that the job of markets is to predict what's going to happen in the future. And that is true. But what we know, as well as we know anything about markets, is that they systematically overshoot and undershoot. And they do this time and time again. And while over the long run, developed countries, stock markets, stock charts move up and to the right and everyone is happy. When you zoom in, they're constantly becoming euphoric and then panicked and back again. Right. I mean, these companies are probably worth less than they were before the AI revolution.

10:28Katie Martin: I would say. But are they worth 40 % of what they were worth? So maybe you will have this basic, and Dara talked about this a bit in his piece, maybe you have this basic data layer that these companies still handle, right? Or the best of these companies still handle. And then where they lose out is like all the fun doodads on top, the kind of user interface, space innovation, look at these new cool things we can do with the data layer, that gets taken over by AI maybe.

11:02Rob Armstrong: The other possibility is that all the enthusiasm about AI itself is like wildly overdone.

11:11Katie Martin: Yes.

11:11Rob Armstrong: So earlier today, Bank of England put out its financial stability report, and it told us lots of things that we know, but are not paying enough attention to or that not enough people are paying attention to. So they were talking about the AI trade writ large, right? We've spoken about this plenty of times on the show. There's all the chip stocks that go to making AI. There's all the hyperscaler stocks, like the companies that buy loads of this technology. And they're all kind of, you know, off to the races and competing with each other and dragging the indices up and everybody's happy. But what the Bank of England is saying is, first of all, as we know, the concentration risk here is crazy.

11:51Rob Armstrong: there's a tiny number of stocks that are lifting up the whole world holding up an awful lot of sky so bank of england was saying the s &p 500 so the kind of go-to u.s stocks index as a whole accounts for about half of the global equity market which is like mad right and within that index it says ai companies now account for about half of that up from about a quarter in 2022 so like the entire global stock market is balancing on this tiny, tiny pinhead that is like a tiny number of AI stocks. And you've got these stock valuations that are like pumped up by incredibly bullish forecasts of earnings growth.

12:34Rob Armstrong: But we still don't actually know how this technology works, how you make money out of it, where the bottlenecks are. So they sketch out a hypothetical scenario in which AI related stocks take a nosedive, by which they mean, what if we saw a 45 % drop in the US stock market over six quarters as a result of this going wrong? They're sketching out extreme scenarios here, but how do you like that? So what they're doing this exercise for is to say, how would this affect the UK economy? And how would this affect UK financial stability? And the answer is, we'd probably be okay over here, because we haven't got very much AI in our stock market.

13:12Rob Armstrong: We're not quite so reliant on it as a theme. But my point is just that central banks are like banging the drum and they're being the monkey on your back saying, you have to think about what happens if this all goes wrong. And there's a number of reasons why this could go wrong. And everyone is ignoring them because the line is going up and to the right. But we should be more worried about this.

13:33Katie Martin: I think so. But let me complicate the story for you a little bit. 45 % is a big decline in the market. That's like 2008 style. But I will say this, stock markets go down by say a third all the time, not like every year, but like, you know, in a decade, that'll happen a couple of times, you know, and if you're not planning for that, you're doing it wrong AI aside.

14:00Rob Armstrong: That's point number one.

14:02Katie Martin: Point number two, we all but know that in massive technological revolutions, there is the inflation of a bubble and then a shakeout. And there is every reason to believe that will happen in this case. But that piece of information plus$20 will buy you exactly one ticket to the movies, right? You know what I mean? It's like, yeah, but when and why and which part gets hit the hardest? You know what I mean? There's a sense that it's like, thanks for the warning bank of England. And now I'm going to get back to living in real life where I have to make decisions. So like, I guess you could make a case.

14:46Katie Martin: If you are an equity investor, make sure you are diversified away from the top half of the capitalization spectrum in the United States and out of the United States.

14:57Rob Armstrong: You know, good luck with that when it when it's so big. Yeah, I mean, look, I think you're right. You get a lot of these things from from central banks and others that are effectively like CYA exercises, right? Cover your ass. So if and when this does go wrong, they can say, I don't want anyone to say that we did not notice this the way I didn't notice the

15:16Katie Martin: housing crisis coming in 2008, basically.

15:19Rob Armstrong: Yes. As ever, you know, investors who are used to kind of, you know, looking at numbers on a screen and figuring out what's fairly valued and what's undervalued and what's too expensive. Now they're being asked to say, okay, but imagine the whole world, but totally different where AI is either completely incredible and it overtakes everything or actually it's rubbish and the markets crash. What are you supposed to do with that information? So I guess this is why you get things like software stocks having a really bad run. And you get this change in leadership that we've spoken about before between the hyperscalers and the chip makers.

15:57Katie Martin: A lot of general volatility.

15:59Rob Armstrong: Yeah. So markets look like they're kind of just sailing higher. But there's some really big questions under the surface. And regrettably, neither Rob nor I know the answer to them. If you do, unhedged at FT.com. In the meantime, we'll be back in one second with Long Short.

16:25Rob Armstrong: Okie doke. It is time for Long Short, that part of the show where we go long a thing we love or short a thing we hate. Rob, what are you saying?

16:33Katie Martin: I'm going long an individual person who I know almost nothing about. I am long Keith Snyder, who is senior equity analyst at CFRA Research. And I am long Keith because he is the one analyst so far as I know who has a cell rating on SpaceX. Yeah. And I have no idea whether SpaceX deserves a sell rating, whether Keith Snyder's work on the topic is good or not. But I do know that the ratings from the big Wall Street banks read something like this. Buy, buy, buy, buy, buy, buy, buy. And it's nice that somebody out there, for some reason, is taking the other side of that disagreement. Yeah. So good on you wherever you are, Keith Snyder, Senior Equity Analyst at CFRA Research.

17:38Rob Armstrong: Go, brother. We believe in you. I am going to have to be long integrity. I bet you know where I'm going with this, Mr. Armstrong.

17:50Katie Martin: I do.

17:51Rob Armstrong: So monkeying about with benchmarks is bad. We know this because people got in lots of trouble for monkeying about with the LIBOR benchmark and people got in lots of trouble for monkeying about with currency benchmarks. But news reaches us that three big US egg producers have agreed to settle accusations by the US and state authorities that they colluded to manipulate the benchmark for the price of eggs. I just think this is a massive scandal.

18:20Katie Martin: Yes, it's food. People need to eat eggs.

18:23Rob Armstrong: You can't just, you know. You can't be messing about.

18:25Katie Martin: It's all fine and good to mess about with LIBOR. A little light insider trading between friends is fine. But you mess with the eggs.

18:35Rob Armstrong: Well, first of all, I think as a point of principle, yes, it's eggs, it's food. You can't just do this. This is like protein that humans need. But the other bit of it is, do you remember that whole period when all of the kind of benchmark inflation data was completely sent bananas by the price of eggs? And because it looked like the price of eggs had gone up massively because of an outbreak of bird flu, all of a sudden the inflation readings were much, much higher than we thought they should be. And there was this wild, wild gyrations in the price of eggs that were completely screwing up the inflation numbers.

19:07Rob Armstrong: And now it looks like a lot of those gyrations were like possibly made up. I think this is like a data, again, integrity. I hope you get my joke. A data integrity issue. Oh, we got it, Katie.

19:23Katie Martin: Thank you. Thank you for that. I just want you to know, I am very tempted to make another egg on here, but I'm not going to do it.

19:29Rob Armstrong: So on that extreme, on that excellent point, I'm sorry, I'm sorry. We are going to be back in your ears on Thursday. So listen up then. Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Forehead. Special thanks to Laura Clark, Greta Cohn and Natalie Sadler. FT Premium subscribers can get the Unhedged newsletter for free and a 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Katie Martin. Thanks for listening.

20:24We'll be right back.