Updated from 1:23 p.m. EDT

Merrill Lynch upgraded the hard-pressed technology sector Wednesday and helped push the

Nasdaq

to its highest level in two months.

Analyst Steve Milunovich, who has been underweight on the sector since early January, raised his call to market weight, saying he believes spending on technology products could improve in the second half of the year and "valuation is not extreme."

Technology stocks are trading at a 28% premium to the

S&P 500

, which is close to its 15-year average and at 21 times forward earnings, the sectors P/E ratio is slightly below its average of 23 times.

Also a plus: the delay of options expensing until next year, which could help tech stocks rally this summer, Milunovich wrote in a note to clients.

Tech stocks responded in kind, with the Nasdaq adding 26 points, or 1.3%, to 2031, its best close since March 15. Even with the gain, the index is off more than 6% this year amid concerns over slowing IT spending, a softening economy and fears that bottom lines will take a massive hit once technology companies are forced to expense options.

Clearly, those problems have not gone away, but Milunovich's note, coupled with good news about core inflation, cheered tech investors.

Software stocks, as measured by the Goldman Sachs Software Index, rose 1.5 Wednesday, with

RSA Security

( RSAS) up 6.4% to $11.69 and other Internet security issues, including

Symantec

(SYMC) - Get Report

leading the pack.

Chip stocks, too, participated once again in the move higher, with the Philadelphia Semiconductor Index gaining 1%, advancing for the sixth straight session to a one-month high. Of the index's 17 member stocks, only

Applied Materials

(AMAT) - Get Report

,

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Micron

(MU) - Get Report

and

Maxim Integrated Products

(MXIM) - Get Report

failed to book gains.

Infineon Technologies

( IFX) and

STMicroelectronics

(STM) - Get Report

, Europe's two largest chipmakers, led with gains of 3% each.

Chip stocks have represented an area of strength for the technology sector since the start of May. Industry stocks have

quietly advanced, as investors have grown more confident in the growth prospects for the second half of the year.

The gains have culminated this week with several significant barriers being breached, most notably with

Intel

(INTC) - Get Report

moving firmly past $25 to a 10-month high and briefly trading above $26 on Wednesday, the SOX breaking above its 50-day simple moving average, and the

Semiconductor HOLDRs

(SMH) - Get Report

exchange-traded fund stepping up to a two-month high of $33.52.

Staff reporter Chris Kraeuter contributed to this story.