Retreat from Defense Stocks?

 Although the federal budget deficit is shrinking, it is still running at roughly -$550 billion for fiscal 2013.  Politicians are struggling to find the right combination of tax increases and budget cuts to address the shortfall.

One area that seems almost certain to see cuts is the defense budget. With the U.S. presence in Afghanistan winding down, and hopefully no significant wars on the horizon, it seems logical to ask whether our spending on defense - which is currently more than the rest of the world combined - shouldn't be pared back somewhat.

Problem is, much of the defense budget is related to personnel costs.  Merrill Lynch defense and aerospace analyst Ron Epstein - who I had the chance to hear yesterday - points out as one example that military pilots today actually make more money than their commercial brethren.  In an all-volunteer military, the government has to offer benefits comparable to those in the private sector in order to attract and retain quality service people.

That leaves spending on military hardware.  Many analysts question the need for the U.S. to keeping adding to its arsenal of ships and aircraft.  U.S. Defense Secretary Hagel has proposed a $52 billion cut in defense spending for fiscal 2014, for example, mostly through the retirement of seven cruisers and termination of the C-27 aircraft program.

It would seem logical, then, that the defense stocks - Northrop Grumman, Lockheed Martin and Raytheon - should be poor performers in anticipation of reduced future spending.  However, as the chart above indicates, this has clearly not been the case.

What's going on?

Ron has been bearish on defense stocks, and remains resolutely a seller of the group despite their strong momentum.  He thinks that investors are buying the stocks due to their strong cash returns and high dividend yields, and are blithely ignoring the bleak outlook for their business.

I asked Ron if the outlook was really as bad as he believes.  After all, most of the ships and airplanes in use today was built during the Reagan years, meaning they are nearing 30 years old.  Simple wear-and-tear, and some technological obsolescence, would seem to warrant a fleet upgrade, regardless of budget concerns, in my view.

Ron does not disagree with my view, but believes that future defense spending will focus on smaller programs, with an eye towards fighting smaller wars. 

I am not totally convinced that the defense stocks are a "sell" but Ron has been following the group for a long time, and usually has a pretty good perspective on the stocks.