Citigroup highlights that the software and services sector is undergoing a significant valuation reassessment driven by fears of AI disruption. According to the bank's latest US equity strategy report published on February 6, the current market sell-off is not due to short-term fundamental deterioration but rather stems from investors aggressively repricing the sector's terminal value.
The report indicates that the market is pricing in a structural decline in future profit margins. Current stock prices already fully reflect an expected 10% compression in terminal multiples and are approaching levels that account for a 20% compression. However, if AI's impact on business models leads to a terminal multiple compression of 30%, stock prices could fall to their lowest levels since 2023 or even lower. For investors, while a short-term rebound may occur due to oversold conditions, the long-term uncertainty introduced by AI signals the end of the era of easy gains for software stocks. The sector is now entering a phase of intense individual stock differentiation.
The substantial contraction in terminal value stems primarily from AI disruption fears. Citigroup's report emphasizes that the sharp decline in the software and services sector—down 20% year-to-date and 28% since October 29, 2025—is fundamentally driven by concerns about AI-related disruption. Although these concerns have not yet fully manifested in short-term earnings reports, they are clearly reflected in stock prices through the compression of terminal multiples.
Microsoft, which holds a 55% weighting in the sector, has seen a 17% decline since its January 28 earnings report, driving the overall sector's downward trend. Citigroup believes the market is rapidly pricing in expectations of lower future profit margins, leading to a reassessment of long-term growth prospects. Despite recent strong fundamentals, valuation headwinds have already emerged. The current decline suggests the market views AI not just as an enhancement tool but as a potential disruptor of existing business models, directly impacting the long-term valuation premium investors are willing to pay for these companies.
Profit margins in the software and services industry have reached historical highs, approximately 30%, a factor previously fully—and perhaps excessively—priced into valuations. Citigroup warns that if profit margins revert to their trend line or fall below it, valuations could suffer significantly. Should margins decline from the current 30% to the trend level of 28% over the next three years, terminal price-to-earnings multiples would need to compress by 10%. A further decline to 26%, one standard deviation below the trend line, would necessitate a terminal P/E compression of 20% to 30%.
Citigroup's model analysis shows that current stock prices already fully reflect a 10% terminal multiple compression and are nearing levels that account for a 20% compression. This indicates that a considerable portion of the expected business model deterioration is already priced in.
Using a reverse discounted cash flow model, Citigroup analyzed the current pricing logic. The market's present price level roughly reflects a terminal multiple reduction of 10% to 20%. In a pessimistic scenario where investors conclude that AI disruption requires a 30% terminal multiple reduction, current stock prices still possess significant downside potential. Under this extreme scenario, the software sector would retreat to price levels seen in mid-2023. If terminal multiples were to fall by 30%, companies would need to deliver growth far exceeding current sell-side consensus expectations in the short term to support current stock prices. The market consensus anticipates a 19% compound annual growth rate for EPS over the next three years, which appears reasonable under a 10% terminal multiple compression scenario but offers insufficient safety margins under a 30% compression scenario.
From a relative valuation perspective, the software and services sector's premium relative to the S&P 500 has narrowed substantially. The enterprise value-to-sales premium has returned to early 2023 levels. The enterprise value-to-free cash flow premium has retreated to early 2021 levels. The forward price-to-earnings premium is approaching decade lows. While these metrics suggest valuation correction has been severe, Citigroup cautions investors against relying too heavily on historical comparisons, as these low valuations could transform into value traps if fundamentals are genuinely disrupted.
In trading terms, Citigroup observed spikes in trading volume and implied volatility for major software ETFs. Such extreme trading activity often characterizes a selling climax. Citigroup strategists believe this panic selling may indicate that price action is entering a more stable phase, potentially even setting the stage for a short-term rebound.
Citigroup concludes that while the year-to-date adjustment has been painful, it has rapidly released some structural risks. With a 10% to 20% terminal multiple compression already priced into stocks, the market might find short-term relief. However, the terminal value crisis introduced by AI will not simply vanish. The bank emphasizes that future trading patterns will no longer feature uniform sector movements but instead exhibit high levels of idiosyncratic performance. Investors must distinguish between companies that can leverage AI to enhance their businesses and those whose business models may be fundamentally disrupted by AI. As Citigroup noted in its 2026 outlook, this represents a more volatile bull market, with software stocks currently experiencing the most intense part of that volatility.