Technology Sector Leads the Pack

If the stock market is heating up, then the technology sector is on fire.

The tech-heavy Nasdaq Composite Index gained 18.6% during September and October, the biggest two-month rally since the end of April 2009, just as the market was bouncing off its lows. That trounced the 12.8% gain of the Standard & Poor's 500-stock index. The nearly six-percentage-point gap between the two is also the widest since April 2009.

The Nasdaq's outperformance, coming after several months of the index lagging behind the S&P 500 and the Dow Jones Industrial Average, has been juiced by many of the same factors that have driven the broader market.

Friday, stocks reached fresh two-year highs on a report of stronger-than-expected job growth for October. Worries about a double-dip recession have eased, thanks in large part to expectations—fulfilled last week—that the Federal Reserve will step in to help prop up the economy.

Tech stocks have gotten an added boost, though, from accelerating growth in overseas markets, which has led to increasing demand for computers and gadgets. As well, the new money that will be injected into the financial system, courtesy of a $600 billion bond-buying program planned by the Fed, has increased investors' appetite for risk, which has driven them to tech stocks.

When tech stocks are outperforming, it is usually a sign that the broad market has room to run.

"Tech stocks are often one of the top-performing sectors in the first part of a bull market," says Jim Stack, president of InvesTech Research in Whitefish, Mont. "The market is hitting on almost all cylinders."

Some say the Fed has set the stage for a continued rally in the Nasdaq, which ended Friday at 2578.98, up 2.9% for the week, its highest close since January 2008. The Dow and the S&P 500 closed at their highest levels since September 2008.

By some measures, technology stocks are still considered relatively good value.

Tech stocks in the S&P 500 are trading at a price/earnings ratio of 13.9 times forward earnings, only slightly higher than the 12.7 times on the entire S&P 500.

And the tech sector, which usually has the highest P/E of the 10 S&P sectors, ranks sixth as of Nov. 2, according to Howard Silverblatt, a senior index analyst at S&P. The top two sectors, telecommunication services and consumer discretionary, have P/Es of 14.7 and 14.3, respectively.

Tech P/Es are also well below the 21.9 average since 2003.

"Those are attractive valuations," Mr. Silverblatt says. "They're trading on much stronger fundamentals than the usual IT hype."

Tech stocks are getting some added endorsements from Wall Street. Portfolio strategists have been boosting their allocation to tech stocks: Bank of America Merrill Lynch raised its recommended allocation to 20.5% from 19.8% on Nov. 3.

With tech stocks leading the way, other sectors should benefit. The same themes that are driving tech—global growth and quantitative easing—should also help sectors that benefit from growth abroad. Bank of America Merrill Lynch also raised its allocation of energy stocks to 12% from 11.5% as demand for oil from emerging-market companies should push their prices up.

But in some senses, the tech rally has been uneven. The Nasdaq has been pushed higher in part by stocks like Apple, which makes up 20.7% of the index, and Google, which accounts for 4.68%. In September and October, Apple (NASDAQ: AAPL) gained 24% and Google (NASDAQ: GOOG) added 36%. Laggards included Teva Pharmaceutical Industries' (NASDAQ: TEVA) American depositary shares, which gained 2.5% during the same period.