US Defense Stocks Could Rally Into Year End

Short sellers targeted U.S. defense stocks in October, driving the iShares Dow Jones US Aerospace and Defense Index ETF (ITA) to a 10-month low. Few components have been spared in the volatile downdraft, which has also affected mega caps The Boeing Company (BA) and Lockheed Martin Corporation (LMT). A strong bounce into November has raised bottoming calls, but new lows are possible in the coming weeks.

Even so, the sell-off will likely yield a major buying opportunity ahead of new highs. It's hard to envision these issues entering bear markets in a presidential administration committed to confrontation and higher defense spending. A divided Congress is unlikely to alter this equation, even if peace breaks out in the world's hot spots. Given this tailwind, it makes sense to watch for signs that sellers have completed their work, allowing these issues to recover points at a rapid pace.

The iShares Dow Jones US Aerospace and Defense Index ETF — an exchange-traded fund that seeks to track the investment results of an index composed of U.S. equities in the aerospace and defense sector — ended a two-year advance in February 2018, doubling in price before stalling just above $200. That level marked resistance into an August breakout that posted an all-time high at $208.83 on Oct. 3. Price action into November has unfolded through a failed breakout that is carving a potential Elliott five-wave decline, with a fourth wave bounce nearing completion. If so, the fund could hit a new low, perhaps in reaction to Democratic electoral gains.

The weekly stochastics oscillator has turned higher at the oversold level but not crossed into a buy cycle. This positioning could presage a small or aborted fifth wave, briefly undercutting the prior low in a selling climax. A bounce above the October low at $182.35 would then issue a buying signal, raising the odds that the correction has come to an end. Dip buyers could prosper with this turnaround, taking exposure ahead of a strong bounce into new resistance above $200.

Aerospace giant Boeing relinquished its longstanding reputation as a market leader in February 2018, topping out above $370 after a 245-point, 18-month uptrend. The subsequent downturn found support near $310, yielding a bounce that stalled at range resistance in June. The stock broke out in September, posted an all-time high at $387 three days later and sold off to the 200-day exponential moving average (EMA) last week. The aircraft makers shares are the largest holding in the ITA ETF portfolio, at 12.23% weight, according to fund sponsor iShares.

A bounce into Friday's close reached 50-day EMA resistance, raising the odds for a fresh downturn that could test the corrective low. This stock has held up better than its rivals, which have broken their 200-day EMAs, and could bounce more forcefully when the correction comes to an end. However, all bets are off if sellers break 2018 range support because that bearish event is likely to coincide with a test at the psychological $300 level. 

Lockheed Martin, the world's largest defense contractor, rose more than four-fold between 2013 and 2018 before topping out at $363 in February 2018. It tested that level in April and turned sharply lower, carving a series of lower lows that reached a 15-month low at $283 last week. The stock bounced back to $300 on Friday, but sellers could retake control in the coming sessions because the stock is now trading well below the 200-day EMA.

The monthly stochastics oscillator remains in a long-term buy cycle, while the weekly indicator has just reached the oversold level. This relative positioning raises the odds for a strong recovery, but exact reversal timing won't be easy to predict. Given strong downward momentum, it makes sense to stand aside right here and let the fast-fingered crowd build a more predictive price pattern, perhaps centered just below the $300 level. LMT shares are the ITA fund's third-largest holding, at 7.28% of the portfolio.

The Bottom Line

U.S. defense stocks should bounce strongly into year end, but it isn't wise to catch these falling knives until they complete intermediate bottoming patterns.

<Disclosure: The author held shares of Lockheed Martin in a family account at the time of publication.>

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