September 8, 2017 / 6:04 PM / a year ago

U.S. defense rally may stall even as North Korea tensions flare

SAN FRANCISCO/NEW YORK (Reuters) - Investors have flocked to U.S. defense stocks amid escalating tensions with North Korea and President Donald Trump’s promises to boost the military, but with towering valuations, their steepest gains may be behind them.

Traders work on the floor of the New York Stock Exchange (NYSE) in New York, U.S., August 22, 2017. REUTERS/Brendan McDermid

The S&P 500 Aerospace & Defense index .SPLRCAERO has risen 23 percent year-to-date, more than double the S&P 500's .SPX 10 percent increase, and is set for its strongest annual gain since 2013.

Partly due to the situation with North Korea, the index is now valued at about 20.5 times earnings estimates for the next 12 months, its highest since 1999, according to analysts. While defense stocks may continue to spike briefly when rhetoric between Washington and Pyongyang is at its most aggressive, strategists question whether valuations can expand much more.

“To have significant outperformance, it would take large-scale military operations, or a belief the global economy is significantly weakening,” said Jeff Morris, head of U.S. equities at Aberdeen Standard Investments in Boston.

The defense sector’s fortunes may depend more on budgetary matters. If tensions over North Korea stay high, it may be easier for a deeply divided U.S. Congress to pass the 2018 budget, Morris said.

Still, investors should be realistic about spending growth.

“The expectation is that you are going to have a larger increase in the defense budget, but I think some of that is a little too bullish,” said Morningstar analyst Chris Higgins, pointing to fiscal hawks in the Republican Party.

Trump, a Republican, tweeted on Tuesday that he would let Japan and South Korea buy more U.S. military gear, but government approval of weapon sales to foreign countries can take years.


The potential profit boost from a war with North Korea is difficult to estimate.

Such a conflict could require additional U.S. spending of at least $100 billion, according to research firm Capital Alpha Partners. The military cost of invading and occupying Iraq from 2003 through 2010 was about $715 billion, it said, citing a Congressional Research Service report.

Lockheed Martin Corp (LMT.N), the maker of F-35 fighter jets and the Pentagon’s No. 1 weapons supplier, said in August that customers were increasingly asking about missile defense systems.

But while the U.S. invasion of Iraq helped Lockheed increase 2003 sales by 19 percent, according to the company’s quarterly filings, it did little for the stock price. The shares jumped 8 percent in the week before the March 20, 2003, invasion but were down 5 percent a year later.

Lockheed shares, up slightly on Friday, have risen more than 21 percent so far in 2017 and are on track for their biggest annual gain since 2014.

If a stock market correction occurs, the defense sector may prove more resilient because weapons are still must-have items for governments.

But the sector’s financial performance does not look poised to catch up with stock gains. While analysts expect S&P 500 aerospace and defense companies to increase earnings per share by 10.3 percent in 2017, they see revenue growth of only 1.1 percent, according to Thomson Reuters I/B/E/S.

“Maybe the bottom line is that the stocks are a little ahead of fundamentals,” said Sameer Samana, global quantitative strategist at Wells Fargo Investment Institute in St. Louis.

Reporting by Noel Randewich in San Francisco and Sinead Carew in New York; Editing by Lisa Von Ahn and Paul Simao

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