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In Defense of Defense

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War is good for defense stocks. Right? So why have defense contractors taken it in the shorts over the last few weeks?

Actually, there is a false premise in thinking that war is good for defense stocks. In reality, PRODUCTION and further ANTICIPATED production is good for defense stocks. Hold that thought and we'll get back to it in just a minute after this important housekeeping message.

Important housekeeping message: this column today isn't so much about defense stocks as it is about trading and market psychology. It just so happens defense stocks fit the bill very nicely in a contrarian sort of way, which is really what we want to tackle in these few short minutes.

OK, back to defense stocks. . .General Dynamics (GD) is down nearly $10 from $64 to $54 since February 20th; Northrop Grumman (NOC) is down nearly $7 from roughly $91 to $84 since February 20th; Lockheed Martin is down roughly $7.50 from $52 to $44.50 since February 5th; and Raytheon (RTN) is down roughly $4.50 from $30 to about $25.50 since February 5th.

So what happened given the backdrop that the U.S. is about to enter what is reputed to be a costly, drawn-out, protracted war - aka expensive and long? Shouldn't these be stellar days for defense companies who supposedly are raking in the cash as juicy compensation for increased production? After all, these companies have bullets and missiles to produce, not to mention the support services and equipment production - you know, tanks, airplanes, surveillance equipments, food, plus the men and women who use them - necessary for their delivery to their ultimate targets. If this (almost) war is going to go on for years, shouldn't investors be bidding up the share prices as just appreciation for rising revenues and profits?

Sort of. Let me offer my explanation. (I can hear the Homer Simpson-like smacks of the palm against collective foreheads. DOH! I know 'cause I did it too once it was explained to me)

Let's start with the general principal that stocks are priced to reflect an anticipated (but discounted) stream of cash flows. Professional investors aren't stupid (usually, but there are exceptions) and they generally buy to hold in anticipation of revenues growing stronger, others recognizing the value and buying into the same argument, and then sell when the shares are "priced to perfection".

While in the really long term, like over a period of years, they don't always get the "sell" part right - witness March, 2000 to current day - but they do understand selling into strength after they have made their money from buying on weakness. In the case of defense stocks, smart investors were buying as soon as they heard George Bush talking about an axis of evil, and it really became obvious when the U.S. demanded enforcement of existing U.N. resolutions and pushed that issue hard. At that time, in the last half of 2002, there were only scant reports of a weapons shortages and the need to bolster production.

Aha! moment: investors realized that defense contractors would soon see an increased revenue stream and probably increased profits. They started buying. Sure enough, in order to build up munitions in the Middle East, weapons and defense factories had to go into big time production to amass a buildup (stockpile) perceived to be required for a successful wartime effort. And "produce" is exactly what those companies did.

Now, there has to be some assumption that there is no free lunch. Accordingly, it is probably reasonable to assume that these manufacturers did, indeed, make money, and make a bit more. But for the most part, and by all accounts, there would be no war until the time that everything, or almost everything, necessary to win a war were already manufactured, shipped, and ready for use. In war, you don't want to be short of critical widgets if they are necessary for success. On the front line, nobody wants to hear, "Sorry soldier, we're a little behind. Your order for 100 cruise missiles is backed up. But we'll have them to you next week once I confirm with the assembly floor foreman." That doesn't work.

Thus, I think most of the production has already been done. When the battle begins, I would be pretty comfortable with the idea that there are enough munitions and equipment to finish the job quickly and effectively. And perhaps there are a few more as extras just in case. So is it realistic to expect production to remain at 100% like in the preparation for war? Some may disagree, but I don't think so. Generally, no company produces things without further anticipated demand, an order, and the promise of payment. So when the attack bugles and drum corps. sound, I think it's a safe bet that big munitions production runs are over. As an investor, that would be my cue to sell. The revenue has stabilized; the big orders and big profits are already accounted for and booked.

Does this sound like a perfect case of, "buy the rumor, sell the news"? It should. The above helps explain why investors are leaving defense stocks. Buyers have jerked back their bids and sellers have emerged. This may be a chicken/egg thing, and I'm not sure which came first, but while the defense selloff is likely born of the perception of immediate (or darn close) attack, it also, in a political sense, says that investors do not expect the war to last long at all. If they did expect indefinite continuation, it would be reflected in their willingness to hold on to defense stocks in anticipation of replacement orders to those manufacturers. Again, in the political sense, I'd call that good news.

But does this signal a great buying opportunity in defense stocks? To my contrarian way of thinking, I think so. Maybe not this moment, but soon if the war looks to end quickly and decisively.

Here's why. The market is already telling us to perhaps expect a short, quick war effort. I'd believe it because the market tends to price that in and reflect it. If that is so, it leaves a defense contractor's customer, aka the U.S. government, free to focus on the next threat, and start the whole process over again. Of course, the first thing to happen will be another munitions and equipment buildup. That means orders come in and get filled. The contractor gets paid, and the cycle repeats.

Let me add one more thing here. It's always when the last bull bails out of a position that the bottom is reached. I don't know of too many left in the defense sector. Hence we have what would otherwise be called a contrarian play. Any doubters of the notion that bulls are mostly gone need only look at the Defense Index chart (INDEX:DFI.X)

Defense Index chart - INDEX:DFI.X (weekly/daily)"

OK, let's be clear. I am not recommending that everyone buy this index as soon as they are finished reading the column. In fact, I'm not recommending that anyone buy it now or later. One look at the increasing negative slope of the 200-dma (magenta) and the 50- dma (gray) ought to convince anybody this sector is on a downhill slide. Bears are at the honey pot and bulls have ground off their horns on this one. What a perfect time to be a contrarian! Look at the buried-for-dead oscillators on both the 5 and 10 period stochastics on the weekly and daily charts. This thing has the stink of sun-ripened herring! Yuck! Who'd want to own it? Who wouldn't want to short it?

Remember my example of natives in the jungle all turning collectively to face the noise from the yet unseen animals that might eat them? While they may be collectively facing the danger associated with the noise, if nobody is paying attention to anything else, it is really the silent danger behind them, which they do not see and do not focus upon, that will eat them. Does it seem like defense investors are staring collectively at anything else but the prospect of declining profits and revenues? Do the shorts see anything else? Have the longs all run for cover and sold the news? The oscillators certainly say so. Yet it is that, which they do not see - namely a pending resurrection of profits in later months if another "axis" country ends up in U.S. crosshairs, as one surely will - that will surprise them the most.

One more thing before we sign off. Take a look at this point and figure chart from Stockcharts:

PnF of $DFI:

Ouch! I feel the bulls' pain. But can trees really fall further once they appear to have hit ground. Well, yes, to the same extent that they can grow to the sky in a market bubble. However, history suggests that with a long tail down, as $DFI has painted, it's bearish days are likely limited. Hence the green (perhaps, but not guaranteed bullish) Alert sign.

To sum it up, we have a "sell the news" event about to take place. Perhaps it already has, which we can see in the buried oscillators and the long tail down on the PnF chart. Is it time to buy? Not in my book, but it's time to watch for signs of bullishness in hopes of getting the jump on a potentially bullish play - a rare find in today's market.

Remember, DFI has likely been sold off on a grand scale by investors based on diminishing expectations. If most are already selling their longs or have gone short, there are not many left to drive the price down further. While a rebound may or may not be possible, I think a bottom in defense stocks may be near. Let's watch for the next few days or weeks and see what these players do when war becomes real.

Until next time, make a great weekend for yourselves!


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