Aerospace & defense components of the S&P 500 (.SPX) rose 1.5% Friday, even as the Dow Jones Industrial Average (.DJI) fell 0.8%. The reason, of course, was the U.S. drone strike that killed Iranian military officials, escalating tensions in the Middle East and raising the potential of full-blown military conflict between the U.S. and Iran.
Defense stocks tend to rally when geopolitical tensions rise. Whether investors should chase the rally isn’t a straightforward decision.
It is true that defense stocks have tended to outperform the broader market for the six months following the eruption of major conflicts. They posted positive returns, as well as better returns than the S&P, after the first Gulf war, circa 1990, after the 9/11 attacks and after the 2003 U.S. invasion of Iraq. Aerospace & defense stocks, however, have lagged behind the market since the September 2019 attack on a Saudi Arabian oil facility.
But four events aren’t a lot to judge by. And there is no guarantee the conflict with Iran will balloon into the worst-case scenario.
“An all-out war would bring much more spending but we believe both sides seek to avoid this, even if it is a possibility,” J.P. Morgan analyst Seth Seifman wrote in a Monday research report. “With so many unknowns, however, we are reluctant at this time to embrace last week’s U.S. strike as an opportunity to buy Defense stocks more aggressively with a longer time horizon.”
Another factor for considering when to buy any stock is starting valuation. The aerospace & defense sector historically trades at a discount to the broader market and was trading at a discount at the onset of each of the three conflicts when shares outperformed.
Defense stocks are trading at a discount to the market now, but it isn’t a large as in previous periods. “We have been reluctant to assume [valuation] multiple expansion from the mid-high teens amid expected deceleration in spending growth beyond 2020-21 and election uncertainty,” Seifman said. He sees other events in 2020, such as the election, also weighing on investor sentiment.
The answer for investors might be to simply keep the defense stocks they like. For his part, Seifman rates L3Harris Technologies (LHX), Northrop Grumman (NOC) and Raytheon (RTN) the equivalent of Buy. He also rates smaller-capitalization Kratos Defense & Security Solutions (KTOS), Mercury Systems (MRCY) and Maxar Technologies (MAXR) Buy.
The Aerospace & defense components of the S&P 500 were down 0.3% Monday morning, giving up some of Friday’s gains. The S&P 500 was down 0.2%.
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