The recent downturn in the stock market, particularly affecting chip stocks, has raised significant concerns about the sustainability of the AI-driven rally and the heightened leverage in the market. The Philadelphia SE Semiconductor Index plummeted by nearly 20% from its late June high, entering a bear market, and is on pace for its largest weekly fall in over a year, down about 9% this week. This weakness has prompted worries among analysts like Tony Pasquariello of Goldman Sachs about the widespread buildup of leverage, including increased retail margin, assets in leveraged ETFs, and short-dated options volume. Toni Meadows, head of investment at BRI Wealth Management, attributes the pullback to profit-taking and increased scrutiny over the long-term viability of AI capital expenditures, noting that semiconductor valuations had become overly optimistic.
The sell-off has disproportionately impacted retail investors, especially those heavily exposed to leveraged exchange-traded funds (ETFs). Assets in these ETFs, which peaked at approximately $218 billion, have contracted to around $198 billion as the market declined, with semiconductor products shedding about 20% of their assets. According to Tyler Neville, co-host of the Forward Guidance podcast, these leveraged ETFs, which must rebalance daily by selling shares as stocks fall, are a "mechanical culprit" behind the rapid decline, amplifying the downturn. This systematic selling, regardless of fundamentals, contributes to accelerated losses, as articulated by Walter Todd of Greenwood Capital, who notes that many investors, used to continuous gains, are now facing margin calls.
Adding to market jitters, Chinese AI startup Moonshot unveiled Kimi K3, a 2.8 trillion-parameter model, the world’s largest open-weight AI system, rekindling investor scrutiny of the potential returns from substantial AI investments by U.S. tech companies. This development, along with a reported delay in Google’s Gemini 3.5 Pro, has intensified concerns regarding AI competition and potential overspending on AI hardware, leading to a rotation out of AI-exposed and momentum stocks. While some large hedge funds have reduced their exposure to AI infrastructure players, options traders appear to be buying the dip and shifting to less crowded sectors rather than retreating entirely from the market, suggesting a rotation in investor sentiment rather than a broad risk reduction. Mechanical rebalancing by leveraged ETFs is a major factor driving volatility, as the spread between single-stock and index volatility has reached a record high, and the selling pressure is expected to continue until volatility subsides and fundamentals regain influence.
