Should You Short Defense Stocks?
Should You Short Defense Stocks?
Rick Whittington, 12.30.10, 6:00 AM ET
Downgrading the defense stocks in summer 2008 to sells in front of a watershed election–combined with a major financial publication’s spring 2009 feature predicting large military budget cuts–led to a lot of flak from major defense companies seeking a more positive hearing. Public remarks of company senior management, in fact, remained outright positive even in the face of a much-reduced political climate for defense spending and overseas deployments that had already achieved what they had set out to accomplish after 9/11. It was apparent that the climate had fundamentally shifted, and that the consensus, which had trebled defense spending from 2001 through 2008 was irretrievably shattered.
The same was true for industrial infrastructure and commercial aerospace two years ago. Massive Fed ease and confidence building steps by elected officials reversed previously bad moves that had raised interest rates well beyond prevailing inflation and elicited imprudent lending throughout the banking and Wall Street communities. After an unexpected global industrial boom in the preceding five years, a normal cyclical correction was turned into a major downturn that led many to predict depression and an era of despondency. Now, of course, it is apparent that the world didn’t end, New Normal just the latest fallacious fad and a resumed global boom is in full swing, which looks to carry corporate profits and stocks a couple more years.
Trained to look at money supply growth and its utilization by the financial system–or the lack thereof–two years ago I was struck by how international trade flows in and out of China (through the trading conduits of Singapore and Hong Kong) were back on the rise. Rather than the slide into severe recession or depression that so many were predicting, it looked to us as if the same global growth dynamic that led the world out of the dot-com downturn in late 2002 was already back at work. This expansionary resumption was seen in statistics that showed rising use of broadband networks throughout Asia and demand for raw materials in the world’s two most populous nations, China and India. Neither fit the bill of the 1930s model that was dominating the airwaves and financial circles.
Today money supply growth is acutely expansive following a lull last spring and summer, while shifting political sands sparking new confidence in the American system is upping the usage rate, or velocity, of those funds. The result is a newly vibrant U.S. economy depicted in Union Pacific’s latest earnings report, with transport rates back to booming across major American industries. Much of the demand for rail service is to supply international markets, but just as has been seen in Germany this past year, there is a rising domestic demand component yet to be factored into popular thinking. Just read how strong the retail figures of this fall and early winter are and one can see the road to full-fledged recovery that lies ahead.
So gripping was the doom and gloom message of the past two years that huge pools of savings and investment are locked up in negative or low-yielding fixed income and alternative asset classes, favored by the purveyors of negativity that have held the public stage. After ruining college endowments, municipal finances and pension fund returns with supposedly sophisticated but ultimately largely sophistical credit instruments, derivatives and statically correlated obligations, the fixed-income mavens scared John Q. Public right out of the equities that are now making their normal cyclical return to favor. Equities across a broad spectrum of industrial infrastructure and technology are trading at or near all-time highs, many paying solid dividends. Not only have prior cycle highs hit in 2007-2008 been taken out, but so have all previous record prices for many of America’s best and brightest.
Clearly, the secular negative case was hooey. So, what lies ahead? Longtime readers know my penchant for global growth stocks, where the outlook is ever brighter as fully coupled nations across the developed, developing and yet-to-emerge spectrum find their economies and financial systems increasingly tightly interlinked. As long as money growth and rate policies remain accommodative, the ensuing contagion effect is positive and expansionary.
Imbroglios in miniscule European nations are overwhelmed by post-unification return to prosperity in Germany; that country is again the locomotive of Europe, pulling along industrial feeder states to the east and purchasing goods throughout the common market. As Japan revs up its capital and consumer good producing engine, the news is about to be as good as it gets, now that legislative roadblocks to growth are being removed in the U.S. Continued expansion by China and India means all of the key players are now aboard.
This backdrop is a disastrous climate for defense stocks. The Afghan war fails to achieve the goals laid out by the new administration, as China-backed Pakistan is an irremediable stumbling block after our leading lights booted out Musharraf for feckless civilians. The inevitable plug-pulling undercuts major achievement in Iraq and will politically lessen support for the conventional force modernization required to offset the nation’s lessened nuclear umbrella wrought by the START agreement. By ignoring massive buildup, the argument will grow that the U.S. doesn’t require the same military deterrent to counter China as it once did the USSR. In the Carter years, the same rationale was offered to justify major cuts in conventional forces. History often repeats.
If the pundits are right and the president is more electable in 2012 because of recent legislative compromise–with the coming economic boom further increasing those odds–then the potential for Clinton-era spending cuts is even greater. Recall that spending has tripled to fight the Wars We Have, but the appetite to retool an aging capital stock has already led to cancelling the technologic masterpiece F-22 in favor of a cheaper, supposedly all-purpose F-35 that does everything, just less well. The ensuing cost overruns are so reminiscent of the disastrous F-X program of the Johnson years, it’d be comical–except its too late to resurrect the F-22, and it will take at least a decade to bring on its successor. Meanwhile, China announces twin-engine air superiority fighters of Russian origin. Then, China continues to build its navy, while we keep downsizing ours. Just lovely.
About half of the post-9/11 defense spending hike went for training, readiness, logistic support and stockpile rebuilding directly tied to Iraq and Afghanistan; the other half went to prosecuting those conflicts and equipment modernization. In today’s political climate, funding will drop back toward the roughly $300 billion previously spent, which even with an inflation adjustment isn’t much more than $400 billion, maybe $500 billion if you really push it. This means at least $100 billion fewer dollars annually for defense contractors once the overseas drawdown takes hold. Whether or not the Afghan withdrawal is this coming year and finalized by 2014 is less important than the fact that a major downsizing in military spending is in keeping with Washington’s new fiscal climate.
The budget trajectory in the 2011-14 period, and hence revenues and earnings in later years, are slowly prompting downgrades across a Wall Street that had remained just as optimistic as company managements after the 2008 election. Our insider’s perspective from decades of interpolating financial fundamentals with diverse political factors led us to an early downgrade following strongly favorable views on defense shares throughout the early-mid 2000s. Even though near-term earnings estimates have been only modestly affected to this point, the P/Es and EV/revenues have already been hit by the waning spending outlook.
The same occurred as the 1980s Reagan defense boom crested and then wound down from the mid-1980s. While many stocks eventually righted themselves, the requisite M&A and restructuring needed to achieve this took much of the next decade; in the interim the shares were dismal performers. If history is any guide, shorting defense stocks now provides investors an excellent hedge against the mirror image boom in global growth stocks like civil aviation, industrial infrastructure and technology. We’d sell and go short Lockheed, Northrop-Grumman, Raytheon, L-3 and even General Dynamics where the latter’s Gulfstream business jet unit is a major growth winner but only generates 20% of the bottom line. Wholesale weapons systems funding cuts cap these stocks and create room for significant downside back to 2002-2003 levels.
The flipside of shorting defense is going long their commercial and industrial offshoots. Countering delays in new generation aircraft, legacy models that carry above average margins are being ramped for the next several years and beyond in response to record airline profits that far exceed forecasts. Increased business air travel and profit margins across industry are bolstering build rates for business and regional jets, while helicopters are needed to access remote locales. Military robotics applied to aerial, subsea and terrestrial commercial applications are spillover beneficiaries of defense budgets that continue to net benefit the civilian economy, propelling this new commercial and industrial cycle beyond the most favorable views yet expressed.
Categories: Food for Thought, North America, Stocks