What Investors Should Know From Monday's AI Sell-Off

Monday’s news that Chinese artificial intelligence (AI) start-up DeepSeek has matched the capabilities of leading American AI models sent shockwaves through certain sectors and industries. The technology-heavy Nasdaq-100 index was hit particularly hard, with the index falling 2.9%.

Many questions abound about DeepSeek. Today, I explain the implications of Monday’s events.

High Profit Margins Attract Competition: Nvidia Corp. (NVDA) is the leader in terms of designing and selling AI processors. Its trailing 12-month gross and operating profit margins are nearly 76% and 63%, respectively. High profit margins attract competition. Challenging an industry leader’s moat requires innovation, lower prices or both. In DeepSeek’s case, restrictions on the sale of Nvidia’s high-end chipsets to China appear to have led to innovation out of necessity.

High Valuations = Greater Downside Risk: A simple investing rule is that high expectations drive up valuations. When the lofty expectations are not met, a stock’s price will fall. This is what happened on Monday. Shares of Nvidia and other AI-associated stocks plunged because traders feared future earnings may not meet expectations. As expectations are adjusted, price movement will follow.

Neither the Nasdaq Composite nor the S&P 500 Index Are the Market: While the Nasdaq-100 lost 2.9% of its value and the S&P 500, as measured by the iShares Core S&P 500 ETF (IVV), slid 1.4% on Monday, the Invesco Russell 1000 Equal Weight ETF (EQAL) declined just 0.6%. The difference stems from high concentration of technology-related stocks—especially Nvidia—in the Nasdaq-100 and the S&P 500. The Invesco Russell 1000 Equal Weight does not have this concentration problem. [For full disclosure, I personally own shares of the Invesco Russell 1000 Equal Weight and the Vanguard 500 Index Admiral fund (VFIAX). My investing club owns shares in Nvidia.]

The Sell-Off Was Not Limited to Tech Stocks: While the average stock fared decently on Monday, shares of companies perceived as being tied to the growth of AI fell. Included in this group were utility companies and engineering firms. Electric utility Constellation Energy Corp. (CEG) lost nearly 21% of its value on Monday and engineering and construction company Quanta Services Inc. (PWR) fell more than 18%.

First-Mover Advantage Doesn’t Always Hold in Technology: What’s occurring in AI right now has me thinking about the 1990s and the 2000s. Yahoo overtook AltaVista and Northern Light as the leading search engine, only to be dethroned by Alphabet Inc.’s (GOOGL) Google. Cell phone makers Motorola, Nokia Oyj (NOK) and BlackBerry Ltd. (BB) were replaced by Apple Inc. (AAPL) and Samsung Electronics Co. Ltd. [Technically, International Business Machines Corp. (IBM) is credited as having released the first smartphone.]

AI Is Still in Its Early Stages: While there are many assumptions, we do not yet know the extent to which people, businesses and governments will benefit from the evolution of AI, or how they might benefit. When the World Wide Web was gaining users, there wasn’t any discussion about mobile devices. Yet now we can pay for our groceries with our phones, join Zoom meetings from anywhere in the world with our tablets, or have our watches send out an alert to emergency contacts if we fall or are in a crash.

Technology Costs Fall Over Time: AI is currently very expensive to train and operate. It is reasonable to expect every aspect of its costs to drop considerably over time, given past trends in technology. It is unclear how much of this anticipated cost drop is already priced into AI-related stocks. But it should be a consideration—especially if DeepSeek leads to other AI systems that can operate effectively on less powerful semiconductors.