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Military Spending Will Support Defense Stocks

Defense and aerospace ETFs have outperformed, and the trend is your friend.

Art Cashin is a managing director of UBS Financial Services and the Director of Floor Operations for the company at the New York Stock Exchange. Art has been around for a long time and learned an important lesson in the early 1960s that has a critical takeaway for today’s markets and geopolitical landscape.

In 1962, when the world was on the verge of nuclear war, Art Cashin was working on the floor of the New York Stock Exchange. The standoff between Washington, D.C., and Moscow caused many traders to sell stocks aggressively as the potential for WW III peaked. Art’s boss at the time told the young trader that selling was the wrong response, reasoning that a nuclear conflict would kill everyone, and the trades would never clear. Meanwhile, a settlement of the Cuban Missile Crisis would ignite a massive, short-covering rally in stocks.

As the war in Ukraine continues to rage in October 2022 and Russia’s relations with the U.S. and Western Europe have deteriorated, Russia’s nuclear threats have increased. The potential for a nuclear conflict has reached the highest level since the early 1960s. Rising interest rates, the strongest U.S. dollar in two decades, and the increasing odds of a global war have caused many market participants to sell stock market holdings and move to the sidelines. Moreover, shorting equities has become more prevalent in the current environment.

While mutually assured destruction is frightening, it remains unlikely. The hallmark of the post-pandemic era has been geopolitical bifurcation — with Russia, China, North Korea, Iran and their allies on one side, and the U.S., Western Europe and their allies on the other. Many market participants are seeking risk havens in “safe” companies that trade on the stock market. One of the most attractive havens could continue to be defense stocks, as increased military spending is inevitable.

The reasons why nuclear war is unlikely: A global nuclear conflict will have no winners. Russia and the U.S.’s nuclear capabilities assure mutually assured destruction. Regardless of political ideology, leaders seek to maintain control; nuclear war is suicide for all sides.

Meanwhile, defense spending reflects the current environment. The war in Ukraine forces Western Europe to increase its military spending. Germany and other European NATO members are on the doorstep of Russian aggression. Post-WW II military spending in Western Europe and Japan is outdated considering the Russian and Chinese alliance vis a vis Ukraine, former Soviet satellites, and Taiwan. U.S. defense contractors stand to profit from the divisions in the geopolitical landscape. Defensive and offensive capabilities can be the most potent deterrent to nuclear war.

The leading stock market indices have declined in 2022. As of October 14, the S&P 500 index was over 24.8% lower since the end of 2021. The DJIA had dropped by over 18.4% this year. The tech-heavy NASDAQ fell by more than 34% since December 31, 2021.

Defense and aerospace ETFs have outperformed the leading indices. The iShares US Aerospace & Defense ETF ( ITA ) at $93.07 per share on October 14 was 9.4% lower since the end of 2021. The Invesco Aerospace & Defense ETF ( PPA ) at $66.43 at the end of last week was 8.1% lower than on December 31, 2021. The SPDR S&P Aerospace & Defense ETF ( XAR ) at $93.31 per share on October 14 was 19.9% below the 2021 closing level. The ITA and PPA ETF products outperformed the leading indices, while the XAR has kept pace with the overall stock market in 2022.

The trend is your friend. Defense stocks are a defensive approach to the stock market. A global military buildup supports earnings for the leading contractors. Raytheon ( RTX ) and Northrop Grumman ( NOC ) are top holdings of the defense sector ETFs and were 4% lower and over 19.9% higher in 2022 as of October 14. The defense stocks have mostly outperformed the leading indices in 2022, and the odds favor a continuation over the coming months and years. Fear and greed drive markets — the fear of nuclear war that could grip investors and traders is why the defense sector is a defensive approach for portfolios.

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