Obama, McCain, and Defense Stocks

These stocks could suffer no matter who wins.


Looking for a defensive place in the market? Don't head for defense stocks.

During downturns, defense and military names often pop up as good bets for cautious investors, especially big-name companies where earnings depend more on resilient government spending than the state of the economy.

This time is different. The defense sector is currently closing out one of its best runs in the past two decades as American military spending finally stirred post-9/11 following a long stretch of slower growth in the 1990s. Now, the economy is slowing, and new domestic problems ($700 billion bank bailout, anyone?) are vying with military spending for lawmakers' attention. Not to mention that it's an election year.

The PowerShares Aerospace & Defense ETF (PPA), which tracks the Spade Defense Index, is down almost 24 percent this year.

Let's parse politics first:

Predictions for the near-term impact of the election on defense stocks are consistent in outcome, though not in scope. Broadly, Sen. John McCain, a longtime hawk, is a positive. A win by Sen. Barack Obama is a negative, given expectations that he'd increase spending on domestic programs at the expense of further military expansion.

Neither prediction rings exactly true, however. The reality is that given the unpopularity and expense of the Iraq war and the slumping economy, both candidates have hinted they're for lower defense spending. What's not clear is how much the rhetoric will translate into real cuts. Both would like to reduce military budgets, mostly through efficiencies rather than program cutbacks.

From the candidates:

McCain: "Too often, parochial interests—rather than the national interest—have guided our spending decisions. John McCain supports significant reform in our defense acquisition process to ensure that dollars spent actually contribute to U.S. security."

Obama wants to add troops, a move many analysts expect will mean less money for large-scale projects.

Obama: "We cannot repeat such failures as the delays in deployment of armored vehicles, body armor, and Unmanned Aerial Vehicles that save lives on the front lines."

Obama and his running mate, Sen. Joseph Biden, also pledge to review major defense programs. Their platform outlines recapitalizing the Navy (especially smaller ships) and large-scale air defense projects like the C-17 tanker and KC-X refueling aircraft programs.

(Compare McCain's and Obama's defense platforms here and here.)

For investors, analysts' expectations for the size of the near-term post-election impact vary widely. Rick Whittington of JSA Research sees the biggest spread for pure-play defense names he follows. Whittington says a McCain victory could push pure-play defense stocks up nicely. An Obama win could send pure-play defense names down by as much as 30 percent. "Senator Obama has made it clear he'll cut defense spending significantly if he wins," Whittington said. "It's a centerpiece of his balanced budget proposal."

Earlier this month, Friedman Billings Ramsey analysts said defense stocks are already mostly pricing in an Obama victory, and see the downside as just 5 percent with a 10 percent upside for a McCain victory.

Tim Quillin, an analyst with Stephens Inc., says it doesn't matter all that much who comes out ahead in the presidential race. Higher national debt and funding costs could cut into some federal programs, but he says much of the bailout will likely be done "off balance sheet."

"Prevailing sentiment is that whoever is elected, we'll have significant changes. Both will scrutinize defense spending, especially big defense programs," he said.

He thinks the spending focus for the military will stay where it's been for the past several years: communication, force protection, and surveillance technologies. That means lucrative work for names like infrared systems maker Flir Systems and unmanned aerial vehicle manufacturer AeroVironment.

But geopolitics can overtake election and current strategies. The long-term spending continuum could shift back to the more traditional variety—think planes, tanks, and ships—as global rivals to U.S. military dominance reassert themselves.