DeepSeek: What Happened and What Are Possible Implications?

Jeff Buchbinder | Chief Equity Strategist

Last Updated: January 30, 2025

Additional content provided by Adam Turnquist, Chief Technical Strategist, Lawrence Gillum, Chief Fixed Income Strategist, and Brian Booe, Associate Analyst.

What Is DeepSeek?

The buzz around Chinese artificial intelligence (AI) startup DeepSeek began to stir over the weekend, prompting a “sell now ask questions later” attitude across tech shares on Monday. AI has been a major investment theme, but this time the headlines didn’t feature new chips or bold development plans. The AI chatbot utilized publicly available open-source models and, according to DeepSeek, performed on par or slightly surpassed the performance of its much larger U.S. rivals, at a fraction of the cost. The company stated costs to train the model - which skeptics were quick to point out cannot be verified and is likely understated - came in at around $6 million, far less than the hundreds of millions in training costs reported by U.S. hyperscalers.

What Happened?

The impressive performance derived from less data and power consumption rattled markets, exacerbating pre-existing scrutiny on outsized AI capital expenditures, U.S. technology exceptionalism, and elevated AI-related equity valuations. Plus, longstanding concerns about market concentration risk and a potential U.S.-China tech war remained in play. Major indexes ended Monday sharply lower in reaction; however, selling was relatively contained to chipmakers and AI-exposed names. Investors rotated into defensive and cyclical pockets of the market, keeping market breadth positive and cushioning losses. Markets continue to reevaluate the AI theme, but dip-buyers briefly stepped in on Tuesday before semiconductor names continued to slide on Wednesday ahead of key big tech earnings reports and amid concerns of tighter chip export controls from the Trump administration.

Market Implications

Monday’s sell-off in the AI ecosystem sparked questions about whether U.S. exceptionalism in the space is overrated. While the jury is still out on that debate, we would acknowledge the AI premium may be too rich if the capital investment needed to employ the technology at a high level is lower than markets expected. Although, good news that may have slipped in under the radar is that the productivity boom may be coming sooner than we anticipated thanks to newfound processes and competition, and it may be cheaper to achieve. Additional positives flagged among Wall Street chatter included a potential Jevons Paradox situation (when a resource becomes more efficient, the cost declines, accelerating adoption and increasing demand) after reports that DeepSeek utilizes previous iterations of chips, which could create favorable demand implications for more efficient computing. Calls that the near-term AI spending threat may be overblown also surfaced.

Additionally, these developments may help accelerate the broadening-out of stock market performance. A broader market is a healthier market, and certainly one that positions active managers to have an easier time finding relative winners. This also serves as a reminder that when markets are concentrated and richly priced, negative news can cause bigger sell-offs.

From an asset allocation perspective, the large amount of good news markets have priced in has underpinned our neutral rather than positive view of the technology sector, and our preference for software over semiconductors in recent months. We expect the solid U.S. economy and rising corporate profits to support a positive 2025 for stocks, but with more ups and downs compared to 2024.

The impact of DeepSeek was also felt in the bond market. Treasury yields fell on Monday, and while day-to-day market moves can be for a number of reasons, the bond market rallied, in part, due to the prospects of additional Federal Reserve (Fed) rate cuts. How does this relate to AI? If DeepSeek’s processes show that the AI revolution can be achieved at a lower cost and with lower energy usage, that would be good for macro conditions (such as productivity and inflation) going forward. In theory, this would help reduce the Fed’s neutral rate a touch and keep interest rates lower than they otherwise would be if big AI spending continued unabated. That said, and as we’ve seen over the past few years, the fed funds market has been the major source of volatility in the bond market with traders (wrongly) betting on the direction of short-term interest rates. But there is still a lot to unpack with DeepSeek and the potential for other AI competitors. If markets are right, that would mean a retest of 5% on the 10-year Treasury is less likely. Time will tell if pricing holds or if it’s another false start by the bond market.

Conclusion

Markets continue to parse DeepSeek’s costs and performance data, while the latest developments include reports of Microsoft (MSFT) and OpenAI investigating whether DeepSeek obtained OpenAI data improperly to build its model. Nonetheless, this could be the necessary competitive jolt for U.S. hyperscalers.

The new approach to AI likely does not jeopardize the bull market, as broader market participation and Fed rate cuts are likely to act as tailwinds. From a technical perspective, the S&P 500 remains near record-high territory amid improving market breadth and momentum. Technical damage within the heavy-weight tech sector has been minimal as buyers stepped up near support from the mid-January lows. Despite Monday’s pullback, sector breadth is also holding up relatively well, with the majority of tech stocks trading above their 200-day moving average. However, technical damage has been more pronounced on a relative basis, as the tech sector vs. S&P 500 ratio chart recently dropped to multi-month lows.

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Article written by Jeff Buchbinder

Jeff Buchbinder, CFA, provides the top-down view of the stock market for LPL Financial Research. He has over 25 years of experience in equities.