Software stocks have collapsed, and no one "dares to catch the falling knife."

The U.S. software sector experienced its worst sell-off since 2022 on Wednesday, but the "bottom-fishing funds" that usually rush in during tech stock declines were conspicuously absent.

After plummeting nearly 4% on Tuesday, the S&P 500 Software and Services Index fell another 1% on Wednesday, marking its sixth consecutive trading day of decline. Unlike previous market pullbacks, this sell-off failed to attract any significant buying interest.

Options traders are also avoiding software stocks, with trading flows indicating that investors are ramping up defensive positions rather than seeking buying opportunities. Even Microsoft, traditionally seen as a safe haven, has not been spared, with short sellers increasing their positions against the trend.

This sell-off in the software sector is the most severe since 2022. The rise in interest rates in 2022 had severely impacted software stocks, but the current market sentiment has shifted from valuation concerns at that time to deep anxiety over the potential disruption of traditional software business models by AI technology. The collective avoidance of buying on dips by investors suggests that the market's view of the software sector may be shifting from a short-term adjustment to a structural re-evaluation.

Bottom-fishing funds missing in action

Steve Sosnick, chief strategist at Interactive Brokers, noted that in stark contrast to the precious metals and semiconductor sectors, there is a clear lack of enthusiasm among the company's clients for bottom-fishing in software stocks. "Overall, our clients' willingness to bottom-fish in software stocks is far less than in precious metals and semiconductors," he said. "While there may be clients buying software stocks, it is certainly not the focus of their trading activity."

This cautious attitude is even more pronounced in the options market. Chris Murphy, co-head of derivatives strategy at Susquehanna Financial, pointed out that the software sector remains under pressure, with options trading flows still dominated by defensive maneuvers.

In the options trading of the iShares Expanded Tech-Software Sector ETF and ARK Innovation ETF, traders are increasing their downside exposure rather than buying on dips. On Wednesday, IGV fell 3%, and ARKK ETF plummeted nearly 7%. Murphy stated that the overall tone for the software sector remains defensive.

Microsoft stands out, but short sellers swarm in

Sosnick noted that Microsoft is one of the few exceptions in the sector, and although the company is not purely a software business, it has still attracted some buyers. Since reporting earnings on January 28, Microsoft's stock has fallen about 15%, but it rose slightly by about 1% on Wednesday.

However, even Microsoft has not escaped the hunting of short sellers. Leon Gross, a research analyst at S3 Partners, stated that short sellers have been encouraged by the significant decline in the sector, and they continue to increase their short positions even as the stock price remains under pressure.

"Historically, Microsoft has behaved like a reversal stock, where short sellers would cover their positions during declines. But now its trading pattern resembles that of a momentum-driven dilemma stock, with short sellers increasing their positions as the stock price weakens," Gross said. Data shows that Microsoft's short positions have increased by about 20% over the past week