For two years, markets’ belief that the rise of artificial intelligence would usher in a new era of productivity growth has fueled trillions of dollars in stock-market gains.

Nvidia , the maker of the computer chips at the heart of the AI boom, has been in the vanguard of this advance. Wall Street has perceived the company to have an almost unbreachable defense against competition with its offerings of high-tech chips. The company’s rapid growth and windfall profit have helped push other technology firms and the Nasdaq Composite Index to record after record, with giddy investors expecting more of the same down the road.

On Monday, the mood turned sour. DeepSeek, a dark-horse power in artificial intelligence, emerged from China. That rattled big tech stocks, led by a plunge of almost $600 billion in Nvidia , which only last week was the world’s most valuable company. Nvidia’s fall marked the largest one-day loss in market value for any public company.

Last week DeepSeek released an AI model that appeared to perform on par with a cutting-edge counterpart from OpenAI, the U.S. firm at the heart of the AI craze. The twist: Creative engineering tricks meant DeepSeek needed far less computing power. The upshot is that the AI models of the future might not require as many high-end Nvidia chips as investors have been counting on.

“This is kind of classic in our industry,” Salesforce Chief Executive Marc Benioff said. “The pioneers are not the ones who end up being the victors.”

The development turned Wall Street upside down . Nvidia’s stock dropped 17% to its lowest level since October. Chip stocks Broadcom and Micron Technology fell more than 10%. The S&P 500’s technology sector lost 5.6%, its worst one-day decline in more than four years. In all, Monday’s bloodbath wiped out some $1 trillion from the stock market’s value, according to Dow Jones Market Data.

Leon Cooperman , the billionaire stock picker who founded Omega Family Office, is one of many investors who says the euphoria surrounding the sector reached unsustainable heights.

“Every third word out of anyone’s mouth was ‘AI,’” Cooperman said. “Everybody was bulled up in the market. If you have a contrarian bone in your body, you have to look the other way.”

The threat to Nvidia is the largest it has faced since sales of its chips skyrocketed during the budding AI boom two years ago. The chip maker booked more than $63 billion in earnings in its last four quarters, making it one of the most profitable companies of all time, and its shares have surged eightfold since the end of 2022.

For its part, Nvidia praised DeepSeek’s advancements and pointed to strong future demand for its products. Deploying AI models “requires significant numbers of Nvidia GPUs and high-performance networking,” the company said.

Many investors had latched on to the notion that AI would unleash a wave of productivity in the economy while powering continued profits in a handful of technology giants. Several said Monday’s swoon exposed a deep vulnerability in the market: Many investors had crowded into the exact same AI trade.

“It is difficult to know exactly how to make money on AI,” said Mike Ogborne, founder of Ogborne Capital Management, a hedge-fund firm in San Francisco that oversees a position in Nvidia. “This could be the first day of a lot more pain.”

What is DeepSeek?

DeepSeek is the brainchild of Liang Wenfeng, a Chinese technologist who runs an $8 billion hedge fund called High-Flyer. Wenfeng plunged headlong into the business of advanced AI systems about two years ago when he established DeepSeek and made it his mission to compete with the biggest and most well-funded AI startups in the world.

Until recently, though, DeepSeek went largely below the radar. Executives attended Nvidia’s annual conference in San Jose, and the company was a big early buyer of Nvidia’s chips in China. Even after U.S. export restrictions clamped down on its ability to import Nvidia’s most advanced chips, it bought less-advanced chips the company made specifically for the Chinese market.

The big moment for DeepSeek came with the recent release of its “R1” model, which dazzled many users of its app with its ability to reason through tough problems in ways that rivaled—and some say, surpassed—OpenAI’s capabilities. The company’s app quickly rose to become the most popular on Apple ’s iPhone store.

OpenAI CEO Sam Altman on Monday called R1 “an impressive model, particularly around what they’re able to deliver for the price,” in a post on X. He also said it was invigorating to have a new competitor and that his company will move up some of its product releases.

Dan Cleary, a New York-based founder of PromptHub, a startup that helps users improve their queries to AI systems, said he ran DeepSeek’s R1 through its paces by giving it a multistep math problem. DeepSeek solved it in about four minutes—three minutes faster than OpenAI’s o1 took. DeepSeek also showed more of the work it needed to get there.

He then asked DeepSeek to produce an image of a pelican riding a bicycle, and to identify an erroneous phrase (“Dan surfs in Portugal”) he inserted in the text of F. Scott Fitzgerald’s “Great Gatsby.” It did both well.

“It’s the first really good reasoning model outside of OpenAI” that has been widely released, he said, as well as the first very good model from China. DeepSeek will be made available on PromptHub’s platform in the coming days, he added, tying into the excitement around it.

Despite the hype, some chip-industry insiders don’t believe DeepSeek will supplant AI’s incumbents , or that its claims of needing small amounts of computing power to create powerful AI models means Nvidia’s business is doomed.

Some estimates have posited that DeepSeek needed only around $5 million worth of chips to train one of its earlier models, but that ignores the cost of the research and experimentation that went into its development, Bernstein Research analyst Stacy Rasgon said in a research note. It wasn’t clear how much computing power DeepSeek used for the more advanced R1 model.

Because DeepSeek made its research and results public, other AI companies can also adopt them, potentially paving the way for other models’ improvement rather than posing a direct threat to them.

If DeepSeek indeed delivered its model on the cheap, the disruption to the incumbent AI trade could be profound. But the advance could be good news more broadly, said Joseph Amato , chief investment officer at Neuberger Berman, which manages more than $500 billion.

“If you can invest less for a powerful model that has wider adoption because the costs are lower, that’s got to be a good thing for the broad-based economy, all the companies that are using AI,” he said.

A snowballing trade

The run-up in Nvidia and other AI stocks has been marked by speculation across markets, where big tech companies have never loomed so large.

Since a blockbuster earnings report from Nvidia in early 2023 floored investors, everyday Americans and big institutional investors alike have piled into artificial-intelligence stocks, vying for a slice of the profits.

U.S. technology mutual and exchange-traded funds attracted $23 billion of net inflows in 2024, the largest annual haul since 2000 around the time the dot-com bubble burst, according to Morningstar Direct data.

And the seven largest companies in the S&P 500 recently made up 34% of the index’s market capitalization, the highest figure on record, according to Goldman Sachs data going back to 1980. Nvidia alone made up 6.8% of the S&P 500 on Friday, up from about 1.1% at the end of 2022, according to Dow Jones Market Data. It contributed almost a quarter of the index’s total return in 2024.

Some investors say the exuberance surrounding the AI trade has simply gone too far and was due for an abrupt reversal, such as the one that rocked markets Monday. They are positioning for the tumult to continue and warning that the crowded trade could continue unraveling.

“It’s a disruption of this whole narrative that this small cohort of companies is going to be controlling AI progress for years and years to come,” said Rob Arnott , founder of asset management firm Research Affiliates, who has been warning about over-exuberance surrounding AI.

The outsize influence of a few big stocks has led some professionals to argue that the group is more vulnerable than ever before.

“When you see these types of levels of concentration, the megacaps, the biggest companies, tend to have a target on their back,” said Michael Reynolds , vice president of investment strategy at Glenmede. “Whether it’s a regulatory target, whether it’s creative destruction as other companies try to take the mantle. I think we’re sort of seeing that happen in practice today.”

While the day’s plunge in Nvidia shares and declines in other tech stocks pulled the S&P 500 sharply lower, a majority of stocks in the index rose for the day. The Dow Jones Industrial Average added 0.7%, or about 289 points, as blue-chip stocks from Johnson & Johnson to Apple, Coca-Cola to Nike , rallied.

Worries about a market bubble

Two years of nearly unrelenting stock-market gains have spurred numerous calls that markets are on the verge of a bubble.

One reason? The popularity of speculative exchange-traded funds that use leverage, or borrowed money, to amplify the returns of their underlying assets has exploded. Assets in such funds have grown to $100 billion, from about $60 billion at the end of 2022, according to Morningstar.

Monday’s market action highlighted the perils of holding such funds. A $10 billion Direxion ETF that aims to triple the exposure to an index of chip-makers dropped 23%, wiping out all of its gains since late 2023. And a GraniteShares fund that aims to double the daily return of Nvidia shares plunged 34% in its worst day on record.

The growth of leveraged funds has raised concerns that the funds themselves are contributing to the velocity of moves in the underlying stocks they track. In order to maintain their advertised exposure, the funds become sellers of the stocks they track on down days and buyers on up days when they rebalance.

Leveraged Nasdaq-100 and Nvidia funds were both among the five most traded ETFs in the U.S. on Monday.

Nvidia also morphed into one of the hottest trades in stock options, a corner of financial markets known for boom-or-bust bets. More than half a trillion dollars worth of Nvidia options premium changed hands last year, surpassing Tesla , another favorite among traders. Traders pay an options premium when they are purchasing stock bets. By one measure, Nvidia options were more active than those tied to Meta Platforms , Apple, Amazon.com and Microsoft combined, according to Cboe Global Markets data.

There was a surge in bearish bets tied to Nvidia on Monday.

Arnott, of Research Affiliates, said he sees echoes of the euphoria surrounding the inception of the internet in today’s craze.

“Just like buffalo on the plain, human beings herd,” Arnott said. “We do get influenced by the narratives around us. This is how bubbles take shape.”

— Tom Dotan and Jack Pitcher contributed to this article.

Write to Gunjan Banerji at gunjan.banerji@wsj.com , Asa Fitch at asa.fitch@wsj.com and Karen Langley at karen.langley@wsj.com