U.S. chip stocks were the biggest beneficiaries of last year's artificial intelligence investment craze, but they have stumbled so far this year, with investors moving their focus to software companies in search of the next best thing in the AI play.
Tariff-driven volatility and a dimming demand outlook following the emergence of lower cost AI models from China's DeepSeek have shifted the spotlight away from semiconductor shares.
Several analysts see software's rise as a longer-term evolution as attention shifts from the components of AI infrastructure.
There has been a pretty clear rotation in part due to DeepSeek, the semiconductor outperformance last year and restrictions on U.S. chip exports to China, said David Russell, global head of market strategy at TradeStation.
"Investors are looking for the next three-to-five-year stories ... those companies that are going to benefit from what Nvidia has already done."
The Philadelphia SE Semiconductor index (.SOX) has dropped 5.6% this year, while industry heavyweight Nvidia (NVDA.O) has slumped nearly 13%.
In contrast, some software companies have rallied, with Atlassian (TEAM.O), CrowdStrike Holdings (CRWD.O), Palantir Technologies (PLTR.O) and Cognizant (CTSH.O) up between 7% and 19%.
Exchange-traded funds tracking software companies have also notched inflows.
The iShares Expanded Tech-Software Sector ETF has pulled in over $1.87 billion this year through February 28, according to Morningstar data, compared with more than $1 billion in outflows each for the iShares Semiconductor ETF (SOXX.O) and the VanEck Semiconductor ETF (SMH.O).
The inflows to the IGV fund have already outpaced last year's total net inflows of $446 million, VettaFi data showed. The iShares and VanEck chip ETFs pulled in $2.46 billion and $6.55 billion, respectively, in 2024.
The shift is a natural progression for AI investing as the use cases for the technology are primarily in software, said Adam Turnquist, chief technical strategist at LPL Financial. LPL, an investment advisory firm, favors software over chips.
Morgan Stanley also favors software companies as adoption of AI tech increases.
"The second stage of the innovation cycle is when people start utilizing products and that's when the software companies start getting paid ... we're now starting to see the ascendancy of the software part of the equation," said Keith Weiss, equity analyst at Morgan Stanley.
The shift comes as investors question how much longer chips can maintain 2024's rate of growth, when many software companies underperformed.
Semiconductor stocks have also been affected by an escalating Sino-U.S. trade war.
DIVERGENT TRENDS
Analysts who spoke to Reuters named companies including Palantir (PLTR.O), Microsoft (MSFT.O), Oracle (ORCL.N) and Salesforce (CRM.N) as favored software plays.
However, performance of these stocks has diverged sharply this year.
Palantir, which sells AI software to companies, has rallied.
Microsoft and Salesforce are down 4.9% and 12.6%, respectively, hit by a broader selloff in U.S. stocks and as AI returns have yet to meaningfully show up on corporate balance sheets.
Morgan Stanley's Weiss said it could take until 2026 for those returns to benefit some companies.
Valuations are still expensive, with Microsoft and Oracle trading around 27 and 23 times forward earnings, respectively, compared with Nvidia's 24.6, according to data compiled by LSEG.
Still, some investors are willing to play the long game.
"We don't need more Nvidia chips, we need applications," said Lisa Shalett, chief investment officer, Morgan Stanley Wealth Management.
