As technology stocks soared into the stratosphere, they became the darlings of the stock market. Shares of defense contractors, by contrast, have registered even greater gains over the past decade, but somehow managed to elude most investors' radar screens. The table below compares the performance of these sectors, as reported by Barron's. However, defense stocks may be speeding towards a hard landing, if not a thudding crash, according to Barron's.

What Should Worry Investors

Back in the 1990s, the U.S. Department of Defense (DoD) warned that the federal military budget would be declining for the foreseeable future, and encouraged mergers among big defense contractors, says Carter Copeland, an analyst with Melius Research, per Barron's. The DoD also began giving contractors large advance payments during the early stages of big contracts, thus reducing these companies' need for capital. Now those advance payments are due to decline significantly, which will increase defense contractors' up-front investments, and thus reduce their returns on invested capital (ROIC).

Defense Stocks Top Techs

Index 10-Year Total Return Average Annual Total Return
S&P 500 Defense & Aerospace Index 359% 16.4%
S&P 500 Information Technology Sector Index 355% 16.3%
S&P 500 Index 190% 11.2%

Source: Barron's. Total returns include reinvested dividends.

Under the proposed new scheme, announced in August, these early "performance-based payments" can drop to as little as 50% of the contract cost, down from 80% currently, though they also may rise as high as 95%. Looking ahead, the bears also note that ballooning federal budget deficits will add to the pain for defense stocks, by forcing slower growth, if not outright cuts, in defense spending. These potential dangers for defense stocks are summarized in the table below.

The most bearish observers of all may be concerned that defense stocks are in a bubble. A worrisome example from relatively recent market history is the dotcom bubble of the late 1990s, which ended in a crash that saw the tech-heavy Nasdaq Composite Index plummet by 78%. (For more, see also: Market Crashes: The Dotcom Crash.)

What Could Kill Defense Stocks

Old payment system: 80% of costs paid upfront to defense contractors
Proposed new payment system: as little as 50% of costs paid upfront
Slower growth in, or cuts to, defense spending

Source: Barron's.

However, some analysts believe that the new rules will be phased in over time, and apply to only some large contracts, thereby reducing their overall negative impact on the contractors. "Obviously, a 30% cut to the progress payment rate would be a hard pill to swallow, but the DOD’s analysis in the supporting documents suggest that is not a realistic expectation," writes UBS analyst Myles Walton, as quoted by Barron's.

How Investors Should React

Carter Copeland, the analyst with Melius Research, believes that Lockheed Martin Corp. (LMT) and Raytheon Co. (RTN) are the two most vulnerable stocks among leading military contractors. Barron's indicates that it is not yet obvious that defense stocks as a group have reached a top, but suggests that investors consider taking profits among their defense holdings, and rotate towards more defensive investments.

Meanwhile, Zacks Equity Research counters with a positive outlook, based what they find to be reasonable valuations and a broader view of demand that goes far beyond the U.S. government. They write: "with the United States being the largest [worldwide] supplier of defense equipment, it is undoubtedly a golden era for U.S. aerospace and defense stocks." (For more, see also: Is It Too Late to Buy Defense Stocks?)

Zacks adds: "Widespread geopolitical tensions that are prompting nations, both developed as well as developing, to rapidly expand their arsenal should keep the outlook for the U.S. aerospace and defense stocks favorable. On top of that, a steady improvement in global air traffic has given a boost to commercial airplane demand, which is another positive for this industry." The biggest risk, they say, is increased competition from "emerging global players, especially China and Russia."

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