It sounds like a scene ripped from the Watergate era. A Chinese company called DeepSeek is disrupting a host of AI stocks today, with chip-maker Nvidia leading the way down (-16% as of noon ET). Being pulled with it are other chipmakers, tech stocks, and even the energy companies once thought to be needed to help fuel power-hungry AI applications.
A little context
The dominant market narrative of the past couple of years has been that AI is the future of just about everything. Therefore, the growth potential of companies that make the essential and expensive computer chips that run AI applications, such as Nvidia, is impossible to imagine. Six of the so-called Magnificent 7 — Alphabet, Amazon, Apple, Meta, Microsoft, and Tesla (Nvidia is the seventh) — have been huge buyers of those expensive chips.
The prospects of these Mag 7 stocks have seemed so bright that investors have had little appetite for much else. In April 2023, an ETF was launched to track these market leaders (MAGS). The S&P 500 Index is up more than +50% since then, one of the strongest two-year performance stretches for the index ever. MAGS during that same period? Up a stunning +134%!
This weekend, suddenly much of that conventional wisdom was called into question, all because of a previously little-known Chinese company called DeepSeek.
Who?
DeepSeek is a startup founded by the head of Chinese hedge fund High-Flyer. Without the deep pockets of leading US-based AI companies, DeepSeek has succeeded in using less expensive chips and less data to fuel its AI training applications. Importantly, those open-source applications are said to be on par with competitors in terms of quality, including the home-grown applications companies such as Amazon and Meta have been developing as a way to lessen their dependence on Nvidia and other chipmakers.
While these tech stories always take time to fully unpack, the key details are as follows: DeepSeek is open-source. So anyone can verify what these algorithms are doing, and other companies can incorporate and build on these ideas. And crucially, DeepSeek uses much less computing power (perhaps as much as 95% less) to generate similar quality output.
Not surprisingly, this is scaring investors in a long list of companies that live in the AI ecosystem. Concerns that demand for pricey chips will drop is taking down the stocks of not just Nvidia, but AMD, Broadcom, Micron, TSMC, and others as well.
However, it's not just the chip companies at risk. The Mag 7 have poured many tens of billions of dollars into AI, and investors have patiently been waiting for the return on that investment. The idea that AI may be rapidly commoditized by cheaper alternatives puts that future return-on-investment in question.
Investors are also concerned that demand for new energy sources has been overblown. As a result, nuclear energy companies are plummeting today, with conventional energy companies dropping to a lesser degree.
Disrupting the disrupters
“Less expensive and just as good” is a compelling message that has clearly gotten the attention of investors. How impactful and long-lasting will DeepSeek’s sudden entry into the AI space be? It’s anyone’s guess. Nothing happening today is based on an argument against AI or its importance in the future. What is now up for debate is which companies will lead the way and how.
Also noteworthy in all of this is that DeepSeek is suddenly on the radar screens of more than just investors. Only days after DeepSeek released its iOS AI app, DeepSeek R1, it has now displaced ChatGPT as the number one app on Apple’s app store.
Today’s market activity is a reminder that, often, the biggest risks are the ones you can’t see coming. That’s why the timeless lessons of investing are, in fact, so timeless: Take the long view, diversify, and know yourself well enough to know how much risk to take.
Impact on SMI portfolios
Finally, while market down days are never fun for those already invested, this isn't necessarily bad news for SMI investors. For starters, SMI portfolios have much less exposure to the Mag 7 names than most investors, given that much of our Large Company exposure in Fund Upgrading is through FCTE, which only owns one of the Mag 7 stocks currently.
Broadly speaking though, the market concentration of returns in the Mag 7 in recent years has been a thorn in the side of any diversified investor trying to protect against the type of concentrated industry risk we see hitting markets so hard today. SMI has long pined for the days when other parts of the market (think small companies, value, foreign, etc.) participate in the upside to the same degree as "big tech." That's a great environment for SMI's active strategies.
It's way too early to say whether today's market reaction will have legs. This could be the beginning of the end for Mag 7 dominance, or it could just be another story that comes and goes and doesn't change much (at least for a while). There's a bullish argument that this could actually be good for the Mag 6 (excluding Nvidia) because it will reduce their need to keep pouring massive capital spending into more chips and training new AI models, given the huge efficiency gains DeepSeek represents. On the other hand, the bearish argument against the Mag 6 is that DeepSeek has just shown it no longer takes a tech giant with bottomless pockets to create the next great thing in AI. The big-tech earnings calls (and especially the management conversations that follow) should be enlightening — as will the market's reactions to these calls.
Time will tell, and as always, our trend-following processes will be monitoring carefully.