Asset AllocationJanuary 16, 2020

Defense Stocks Are Killing It, but for How Long?

Amid swelling Pentagon spending under Donald Trump, they look good. But under President Bernie Sanders?

Reported by Larry Light

Martial talk has been in the air of late, in connection with Iran and the US’s drone killing of its top commander, General Qassim Suleiman. And despite lowered tension at the moment, questions are stirring about the level of Pentagon spending, which under President Donald Trump has burgeoned.

The current military buildup smells like victory for investors. Defense stocks have bested the market during the Trump Administration. Just compare the S&P 500 to the largest military-oriented exchange-traded fund (5.7 billion in assets), the iShares US Aerospace & Defense. In price terms, the defense ETF is up 54% versus the broad-market index’s 44.8% in the three years Trump has been president.

Whether that Wall Street trend continues depends on who the next Oval Office occupant is, Republican Trump or a Democrat. Among the leading Democratic presidential candidates are Senators Bernie Sanders and Elizabeth Warren, who are on the left side of the party. They think a lot of military spending is wasteful.

In a campaign statement, Sanders complained that “we should not be spending more on the military than the next ten nations combined.” Warren has decried “our bloated defense budget.” The more moderate Joseph Biden told the Washington Post that “we can maintain a strong defense and protect our safety and security for less,” by trimming wasteful outlays.

Regardless, 2020 should be good for military contractors’ stocks. While the Trump presidency has been a golden time for investors in military-oriented equities, election years in general seem good for them, regardless of who wins. Defense shares have outperformed the market in nine of the last 10 election cycles, by 16 percentage points on average, according to UBS analyst Myles Walton.

Big winners nowadays are stocks in corporations like Northrup Grumman, Lockheed Martin, and Raytheon. Although their prices have run up, these contractors aren’t that expensive: Northrup has a price/earnings ratio of 16, Lockheed 17, and Raytheon 18—less than the S&P 500’s. One reason for the tame multiples is that their earnings have jumped, expected to grow from 9% to 15% yearly through 2021, well ahead of the overall market’s profitability.

A sweet spot for defense investors: Any time there is international tension, defense names usually surge, by Walton’s estimate, even when American forces aren’t triumphant. Take al-Qaeda’s October 2000 bombing attack on the USS Cole in a Yemeni harbor, which killed 17 sailors and wounded 39. Defense stocks rose 6% in the following three months.

The military buildup under Trump has been remarkable. The defense budget authorization he recently signed, for federal fiscal year 2020, is $733 billion, up 22% from Barack Obama’s last Pentagon spending blueprint.

With a leftward tilt among Democrats, though, the party’s traditional preference for domestic spending over the military kind surely will come to the fore. Post-Vietnam, Democratic presidents (Jimmy Carter, Bill Clinton, and Barack Obama) have reduced defense appropriations, although not by an enormous amount. A Sanders or a Warren might be more ambitious in their cuts. Not a good thing for defense industry investors.