Software's 20% Selloff: A One-Way Trade That Got Priced In

The market's one-sided bet against software has reached its logical extreme. After a historic 20%+ sell-off in early 2026, the sector is now trading at levels that signal the worst-case AI disruption scenario has been fully priced in. This is a classic "sell the news" event, where the fear of automation has driven valuations down to a point of absurdity.

The evidence is stark. The iShares Expanded Tech-Software ETF has plummeted by 20% so far this year, a rout that has seen the sector suffer its largest non-recessionary 12-month drawdown in more than 30 years. The punishment has been indiscriminate, wiping out $2 trillion in market cap and reducing software's weight in the S&P 500 to a 30-year low. This isn't just a correction; it's a capitulation.

The valuation metrics confirm the panic. At one point last week, the S&P North American software index traded below 20 times forward earnings for the first time ever. That multiple, now roughly 23, still sits well below its long-term average of 34. For a sector that typically commands a premium, this is a signal of extreme fear. As analysts note, the setup has become so one-sided that it skews the balance of risks toward a rebound. The expectation gap is now massive: the market is pricing in a slow-motion collapse, while fundamentals and earnings growth projections remain solid.

The Reality Check: Beats vs. The Whisper Number

The market's priced-in fear is colliding with a stubborn reality. While software stocks have been hammered, the actual operational performance of companies reporting this season tells a different story. The expectation gap is widening, with fundamentals beating the bearish narrative.

Among the 10 S&P 500 software companies that have reported earnings this season, the beat rate is striking. All beat profit expectations and eight topped revenue estimates. That performance exceeds the broader S&P 500, highlighting a disconnect where price action is decoupling from bottom-line results. In a sector where the whisper number for growth has been reset lower by AI fears, these companies are still delivering.

This divergence sets the stage for a potential reversal. When the market prices in a slow-motion collapse but companies consistently beat expectations, the risk is not that the news is bad-it's that it's already been discounted. The setup becomes ripe for a "buy the rumor" rally, where the positive beat surprises are no longer a surprise but the catalyst for a re-rating.

Yet, the outlier cases serve as a reminder that the fear isn't entirely baseless. Monday.com's 21% drop earlier this week after a disappointing forecast shows the vulnerability of any company that signals a guidance reset. If a company's outlook confirms the erosion of pricing power or growth, the market's punitive response can be swift and severe. For now, the beat streak suggests the sector's fundamentals are holding, but the guidance risk remains a live wire.

Market Positioning: The One-Way Trade

The extreme positioning in software has reached a point of near-total capitulation. The sector has lost $2 trillion of market capitalization from its peak, a staggering decline that has reduced its weight in the S&P 500 to just 8.4% from 12%. This isn't just a sector rotation; it's a forced exit from a crowded, one-way trade. The evidence suggests the sell-off has run its course, leaving behind a group of stocks priced for permanent decline.

A key technical signal is the pattern of the iShares Expanded Tech-Software ETF. It fell 15% during an eight-session slide from Jan. 26 to Feb. 4, then rebounded 6.2% in the sessions that followed. This sharp drop followed by a swift recovery is a classic capitulation pattern, where the final wave of weak hands sells into the panic, setting the stage for a bounce. Traders at BTIG have described the group as being in capitulation territory and should be finding a tactical low here.

The valuation data reinforces this one-sided setup. Jefferies, reviewing 64 software stocks under coverage, found that 42% are trading at or near historical low valuations. This isn't a few outliers; it's a majority of the sector. When such a large portion of a group trades at these extremes, it signals that the bearish narrative has been fully absorbed into prices. The expectation gap is now massive: the market is pricing in a slow-motion collapse, while the fundamentals and earnings growth projections remain solid. This imbalance skews the risk/reward toward a rebound, especially for higher-quality names that are resilient to AI disruption.

Catalysts & Risks: The Guidance Reset or The Rebound

The setup now hinges on a binary choice. The expectation gap is wide, but it can close in two ways: a counter-trend rally if positioning reverses, or a deeper sell-off if more companies confirm the AI disruption thesis with a guidance reset.

On one side, the case for a rebound is gaining institutional traction. Market strategists at JPMorgan and Goldman Sachs believe the selloff has gone too far. JPMorgan argues that an overly bearish outlook on AI disruption is colliding with still-solid fundamentals, creating new bargains. Goldman Sachs CEO David Solomon echoed this, saying the selloff was "too broad". This view is supported by the valuation disconnect. With 42% of software stocks trading at or near historical lows and the sector's forward multiple still well below its long-term average, the risk/reward is skewed toward a reversal. Technical traders see capitulation territory, and aggressive retail buying has already begun. The potential for a counter-trend rally is real if this positioning shift holds.

The key risk, however, is that the bearish narrative gets confirmed. The recent 21% drop in Monday.com's stock after a disappointing forecast is a warning shot. If more companies follow suit and issue a guidance reset, it would validate the fear that AI is eroding pricing power and growth. This would widen the expectation gap, moving the market from pricing in a slow-motion collapse to accepting a faster one. The anxiety stems from new automation tools that could pressure revenue and margins if AI services begin replacing existing software packages.

The bottom line is a high-stakes tug-of-war. The valuation disconnect and one-sided positioning create a potential setup for a vicious rally. But that rally is fragile. It depends on the current beat streak continuing and no further guidance resets. For now, the market is caught between a powerful rebound narrative and the very real threat of a guidance reset that could confirm the worst fears.