Defense Stocks: Nothing to Fear but Fear

Stocks in the defense sector have gotten a lot of buzz lately. Many investors are beginning to fear that Washington’s gridlock is going to end badly, and ultimately result in big cuts to our nation’s defense budget.

Now, if this refrain sounds familiar, it should. Last year, we heard the same billowing fears over big budget cuts in defense due to the debt ceiling debate. That debate ended up being resolved by a patchwork deal between the White House and Congress to lift the debt ceiling and cut the rate of growth of some federal spending. Note the cut in the rate of growth, and not an actual cut in total spending.

This year, we have a presidential election, and that means the rhetoric over fiscal issues will be supercharged by both parties. The looming “fiscal cliff” (a combination of automatic tax hikes and spending cuts if no budget deal is reached by year-end) is something both sides will no doubt demagogue all the way through Election Day, and well beyond.

To garner broad-based voter support, we’re likely to hear Democrats and Republicans warning of big and dangerous cuts to America’s military if no new agreement on the federal budget is reached. In recent weeks, I’ve read that up to $1.2 trillion in budget cuts will automatically take effect if no budget deal is reached by Jan. 1. These warnings also estimate that about $55 billion in funding will be erased from next year’s defense budget. That number spikes to $500 billion in defense cuts over the next decade.

Investors who are long the defense and aerospace sector might be apt to fear these cuts and the effect they could have on the sector’s biggest stocks. Well, in response, I’ll borrow a phrase from of one wartime president, and say that the only thing you have to fear is fear itself.

I say this not to be dismissive of fiscal cliff issues because our nation’s budget woes are indeed very real. But the idea that Congress and the next president actually would let so much money flow out of the defense budget is something I don’t think has any chance of happening.

Much like the debt ceiling deal, there’ll be a whole lot of blustery fear-mongering about cuts putting the country, and our troops, at risk. But the last thing politicians want is to have less money to spend on pet defense projects and deliver less largess to their districts. Finally, no representative wants to be accused of abandoning the troops.

I suspect that if there’s any pullback in the defense sector between now and the election, that investors should use it as an opportunity to build positions in exchange-traded funds such as the iShares Dow Jones US Aerospace & Defense (NYSE:ITA), or the PowerShares Aerospace and Defense (NYSEARCA:PPA).

Both funds provide broad exposure to the bellwether defense stocks such as United Technologies (), Boeing (NYSE:BA), Lockheed Martin (NYSE:LMT), General Dynamics (NYSE:GD), Northrop Grumman (NYSE:NOC) and Raytheon (NYSE:RTN) to mention just a few. And while the portfolio allocations in ITA differ somewhat from those of PPA, both are great ways to ensure you have industrywide exposure to this stalwart sector.

Finally, ask yourself this question: If investors are really worried about the fiscal cliff vis-à-vis defense spending, then why is ITA up 9% since falling to its June 4 low, and why is PPA up 11% over the same period? The answer is the smart money knows that Washington, despite its dysfunction, isn’t about to allow the military industrial complex to wither on the vine.

As of this writing, Jim Woods did not hold a position in any securities mentioned here.

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