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Apple and Alphabet have warned of challenges. For Apple, it is securing parts for computers; for Alphabet, it's slowing ad revenue growth.DADO RUVIC/Reuters

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Investors may be wondering if the worst is over for technology stocks after a grinding year-long sell-off.

A rally since mid-June has lifted the Nasdaq Composite Index by 23 per cent. Average price-to-earnings (P/E) ratios have tumbled from 29.6 on Jan. 1 to a current 24.07 as the market re-evaluates the multiples applied to the shares.

But even after the sell-off, the Nasdaq is still down by more than 18 per cent on the year, which some investors see as a signal to buy. So, is it time to jump in?

Analysts say there are bargains to be had for patient investors, mainly among the large and mega caps that have strong businesses, tend to fall least in bear markets and rebound first.

But they caution more weakness lies ahead as consumers and companies absorb interest rate increases and rising inflation. While the latest rounds of interest rate hikes may mean the rate of inflation has peaked, it is still likely to remain high well into next year as are interest rates, they say.

“The worst for tech stocks might be behind us, but I think we’re still going to see another leg down,” says Sadiq Adatia, chief investment officer at BMO Global Asset Management in Toronto. “Valuations are not cheap, they’re just cheaper.”

Mr. Adatia sees the summer rebound as a relief rally as bargain hunters find some stocks attractive after the first-half decline. Some surprisingly positive earnings reports have helped buoy sentiment.

What’s missing for a sustained rebound, he says, is capitulation. So far, investors are hanging in. Traditionally, the bottom is reached when they throw in the towel, which leads to a final round of selling. Mr. Adatia would not be surprised to see average P/E ratios fall further, into the low 20s.

Kristina Hooper, chief global market strategist at Invesco Ltd. in New York, also says the worst may be behind the sector and that more volatility lies ahead. She adds recent rounds of interest rate increases have yet to fully move through the economy but will start showing up in the next month or so as third quarter (Q3) earnings are released.

She expects inflation to remain high well into 2023 even if the rate of inflation has peaked. As a result, interest rates will also remain relatively high.

What the summer rally suggests

Ms. Hooper says if Q3 earnings are broadly weaker, the U.S. Federal Reserve Board may stop aggressive interest rate increases of 50 and 75 basis points. She thinks the summer rally indicates an expectation that this is what will happen.

She notes that while mega cap tech companies have reported fair and, in some cases, good second quarter results, the companies were cautious about what lies ahead.

Microsoft Inc. MSFT-Q stands out as having a strong outlook, while Apple Inc. AAPL-Q and Alphabet Inc. GOOG-Q have warned of challenges. For Apple, it’s securing parts for computers; for Alphabet, it’s slowing ad revenue growth.

“We’ve heard a lot about headwinds,” Ms. Hooper says. “It foreshadows the potential for downward earnings revisions.”

Mr. Adatia says the rally has been confined largely to the biggest companies because their scale and financial depth commands a premium share price.

“That’s the rally you’ve been seeing over the past month or so,” he says. “In an environment in which you’re seeing an economic slowdown, you pay up for that.”

He adds that these companies have pricing power, which means they can pass along some inflationary increases and absorb others more easily.

‘Shaky road ahead’

Mr. Adatia also says the impact of rising inflation and higher interest rates have yet to be fully felt, which makes him cautious about the near term.

Higher inflation is eating into disposable income. Home values are starting to decline. And while the job market is strong, job security is becoming more of an issue as top tier companies freeze hiring and lower quality ones cut employees.

“More of that is yet to come,” he says. “We have a shaky road ahead for the next three months.”

While Ms. Hooper sees the possibility of a sustained September rally if the Fed pivots to a less hawkish path for tightening, Mr. Adatia sees that as less likely. He expects a pullback in September and October, with the potential for a strong rally before the holiday season.

Both are optimistic about the longer term. Ms. Hooper notes that among S&P 500 sectors, technology has the most “buy” ratings at 65 per cent.

“We’re going to see more volatility and downward moves that shake investor confidence,” she says.

“But what we learned from the global financial crisis [in 2008] is that the biggest mistake was getting out close to the bottom and not participating in the rally that extended for years afterwards.”

Mr. Adatia is also bullish on technology because “it is the mainstay of everything we do, whether you’re in the sector, or in another sector that uses technology,” he says.

“If you look out four or five years from now, you know, a lot of these companies are going to be significantly higher than where they’re at today.”

Adam Mayers is a contributing editor to the Internet Wealth Builder investment newsletter.

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