Analysis-US tech stock tumble highlights risk of market reliance on megacaps

By Lewis Krauskopf and Laura Matthews

NEW YORK (Reuters) - Turbulence in some of the biggest tech names is reminding investors of one of the major risks to the U.S. stock market's record-setting rally: Reliance on a handful of mammoth companies to power those gains.

Investors are scrambling to understand the fallout for the artificial intelligence (AI) investment theme that has been a critical driver for stocks over the past two years after the emergence of a low-cost Chinese AI model rattled markets.

Optimism over AI has helped propel shares of chipmaker Nvidia and others of the "Magnificent Seven" megacaps, which combined contributed more than half of the S&P 500's 25% total return in 2024. 

Because of those gains, the Magnificent Seven account for one-third of the weight of the benchmark S&P 500 and about 45% of the Nasdaq 100 - meaning when they falter they have outsized impact on the closely followed market barometers. 

"You run the risk when you have concentration that you have selloffs like this," said Chuck Carlson, chief executive officer at Horizon Investment Services. "It's certainly going to raise questions in terms of how investors are positioning portfolios."

The S&P 500 fell 1.5% on Monday after news of the DeepSeek AI model - cutting the index's year-to-date gain nearly by half -- while the tech-heavy Nasdaq 100 sank 3%.

While it is uncertain "how big a threat DeepSeek itself will be to the AI theme," said Phillip Wool, chief research officer and lead portfolio manager at Rayliant Global Advisors, "it's crystal-clear that there are a bunch of correlated and crowded trades at risk when the tide of sentiment turns."

Shares of Nvidia, the AI poster child whose stunning stock-price rise had propelled it to become the largest company by market value, tumbled 17% on Monday.

Seth Hickle, managing partner at Mindset Wealth Management, said he moved to position more defensively with Nvidia options amid the volatility following the DeepSeek news.

Nvidia "is really widely held," Hickle said. "So this really affects all Americans who have a retirement portfolio or a passive equity investment strategy."        

Just last week President Donald Trump's announcement of private sector investment in AI infrastructure gave a lift to tech stocks and the broader market.

Analysts at Capital Economics said that if it became clear that AI models could indeed be trained effectively with less high-end computing power than had previously been assumed, "there would clearly be a risk of a further correction in the U.S. stock market."

"That’s because this would potentially undermine the dominant positions of some firms that have powered the rally," the Capital Economics analysts said in a note.

INFLECTION POINT?   

Investing in broad market funds that follow the S&P 500 has been a winning bet for the past two years, with the benchmark index posting back-to-back annual gains of over 20%. Many actively managed funds have been underweight the major tech stocks, which was a headwind for the funds' performance.

But the increasing megacap stock concentration in the benchmarks "means that we cannot all be very passively invested as we have been over the last decade," said Shams Afzal, managing director and portfolio manager at Carnegie Investment Counsel.

Some corners of tech were benefiting on Monday as investors assessed the DeepSeek implications, with shares of cybersecurity company Palo Alto Networks and software company ServiceNow both up about 1%.

The DeepSeek news "could lead to some relative leadership shift, which could be other parts of tech, as opposed to just Nvidia," said Tiffany Wade, senior portfolio manager at Columbia Threadneedle Investments.

Horizon's Carlson and others wondered if Monday's AI developments could be an "inflection point" that prompts a change in market leadership or a rotation into other corners of the U.S. market that have not fared as well in recent years.

To be sure, many market participants said the stock selloff could be an overreaction as investors "shoot first and ask questions later" as they sort out the DeepSeek developments.

Josh Pantony, co-founder and CEO of Boosted.ai, a firm that advises asset managers on how to deploy AI, said he is adding AI-related stocks to his personal portfolio “right, left and center” in the wake of the selloff. 

The market will be further tested by a slew of quarterly results this week, including from Apple, Microsoft, Meta Platforms and Tesla - four of the Magnificent Seven.

David Wagner, head of equities and portfolio manager at Aptus Capital Advisors LLC, said the megacap companies exhibit operating leverage, which can continue to drive operating margin expansion.

"No matter how you slice it, the U.S. market is dependent on these stocks, but that's not always a bad thing," Wagner said.

(Reporting by Lewis Krauskopf and Laura Matthews; additional reporting by Suzanne McGee and Saeed Azhar; Editing by Megan Davies and Matthew Lewis)