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Defense Spending and the Presidential Election

by: Scott Sacknoff September 07, 2008 | about stocks: BA / GD / HON / LLL / LMT / MTCT / NOC / PPA    
Scott Sacknoff

Scott Sacknoff

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Although the summer got off to a rough, volatile start, overall the markets drifted in the standard, quiet, sideways pattern typically exhibited as a large percentage of Wall Street goes on vacation or enjoys the summer months.

The defense sector was no different as volume was low (typically of the summer) and while the value of the index had its ups and downs, it pretty much stayed in a trading range following June’s declines.

After seeing a decline in assets in the funds that track the index earlier in the year - as investors cashed out the sizable gains of the past few years - the summer saw the Powershares PPA fund level off around the $200 million level, which it stayed at for the latter summer months.

Inflows Into the Sector

Toward the end of August, we began to see money flow into the sector and the return of at least a few institutional investors. The end of the year tends to be a strong period for the sector as DoD end-of-year contracts come fast and furious in September and October sees the beginning of a new budget cycle. Before we get to comments on the U.S. presidential election and the next budget, we should point out that another reason for the inflow could be the index’s breakout from its trading range with its value passing its 30-day moving average.

Combined with a positive increase in money flow, this is a strong indicator to market technicians that the sector is set to rise. Passing its 200-day average would suggest that the sector is ready for another run.

The Irrationality of the Market

After the Index rose to new multi-year heights, it has fallen more than 20% from these levels since last October - even while companies involved with aerospace, defense, and homeland security continue to report strong fundamentals. The sector is still one driven by perception - one of the few on Wall Street - where long-term changes and shifts can be more important than short-term results. How else can one explain declines in a sector whose companies report ever increasing revenues and profits and backlog and share buy-backs while seeing declines in share prices due to possible budget declines two and three years hence?

Politics & the 2008 Presidential Election

Which brings us of course to the 2008 presidential election in November (so that you don’t have to guess, I am an independent voter and have not decided my vote yet).

Prior commentaries have discussed how the defense budget is as much (or more) a function of world situation than political party. Time has proven that the defense budget has more to do with the world in which we live than who is in charge. For those that question this, WWII and the Vietnam War both took place with Democratic commanders in chief. Even recently, defense budget declines started in the final years of the George Bush-41 presidency and rose in the final years of the Clinton presidency (when it became clear that they had cut too much).

In looking at the candidates this year, I’ve stated that whoever is elected, they will have no choice but to maintain the currently forecasted budget levels as the military recapitalizes, replaces damaged and worn equipment, funds overseas activities, and invests in new systems. The percent devoted to each activity will vary depending on whoever is elected. The timing of when we pull out of Iraq and the rate of withdrawal, will free up funds and shift it toward the aforementioned activites. But the overall level of funding is if anything at a bare minimum advocated by the military leadership. Reducing spending on homeland security or defense and then being faced with any sort of future attack would be political suicide for the ruling party. Hence, changes reducing the defense budget are unlikely.Congress and the White House will likely keep each other in check on this as neither wants to lose power.

However, while the core budget is unlikely to change, I’d be deficient if I didn’t state that the supplemental budgets afforded the military will not remain as high in a post-Iraq environment. Although spending on the war is costing between $8 and $12 billion a month depending on estimates, there are several things to consider. First, there are always defense supplementals added to the core budget for one reason or another - through not at the $50 to $100 billion level of recent requests. With the military needing to recapatilize a number of systems, Congress providing additional budget via supplementals is one way for them to give the appearance of keeping the defense budget down while providing an increase of funds to meet needs. Secondly, a large percentage of the supplemental budget has gone toward items that will not make its way to private companies. Although dollars have flown to companies that manufacture armaments, missiles, armored equipment, etc. supplemental spending also goes toward gasoline and fuel (the U.S. military spends more than $1 billion per month on an estimated 340,000 barrels a day), soldier hazard pay, increased medical expenditures, transportation of supplies, etc.

As far as the candidates themselves, Senator John McCain has been perceived as the strongest supporter of defense due to his military career, his support for continued action in Iraq, and as a member of the Senate Armed Services Committee. His VP candidate, Sarah Palin, has stated that she has not been very interested in international politics so, should she become president at any point, her support of the sector is largely an unknown. As VP, her opinion would likely defer to McCain’s positions. Senator Barrack Obama has said he would pull out of Iraq but keep defense spending stable, taking advice from the military leadership on how quickly to leave Iraq and where to spend available resources. His VP choice, Senator Joe Biden, is a member of the Foreign Relations Committee and considered a knowledgeable and strong supporter of defense and intelligence activities. Although neither has direct military experiences (as a disclaimer, the closest I come is having worked at the Pentagon for a few years and having several friends who are active military), any perceived weakness by Sen. Obama in the area of defense is more than made up by Sen. Biden’s appearance on the ticket.

So which candidate team is best for defense?

Ultimately I believe it is a draw. It is more a matter of direction than budget. Companies benefitting from an increased presence in Iraq will benefit from a McCain presidency. Companies benefitting when resources are devoted to R&D, IT and network-centric warfare, and development for next generation technologies and systems, likely benefit from an Obama presidency (the logic being that if the budget is stable, what isn’t being spent on war consumables will be spent elsewhere). Either way, I don’t see either candidate as having a material impact on defense company revenues, profits, or backlog. The impact from perception, well that’s another story. It’ll be interesting to listen to their answers when the debates start later this month and into October.

Get ready for an interesting fall

I think we’re going to see a lot of volatility for the rest of the year in the market, both in the defense sector and the market as a whole. Considering the fundamentals of the sector, and if the market cooperates, I believe that the sector will see net gains through the end of the year. Getting there, though, might be interesting ride.

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This article has 2 comments:

  •  
    Sep 07 12:03 PM
    As a V/N vet, I can add a little bit of perspective-hopefully useful and as objective as this report is. WE won almost every battle, but lost the one re. the civilian 'stomach for war'. It was our first full scale operation against guerillas under the radar. Just as the intelligence ops were separate and competitive on 9/11, and since has become more homogenized-we are much better at CAS or close air support. Whenever and wherever there are ground soldiers, e.g. Afghanistan's rugged terrain -ideal guerilla topography-we have helicopter gunships, A-10 Wart hogs, and the side firing , night flying, C-130 ordinance platforms all standing by, hovering, and ready to spray fire on any one foolish enough to identify his location by his own muzzle flash. We recently even chased a group into Pakistan and obliterated them, much to the ire of Pakistan. The point being, if any of you watched both conventions, as i did, heard the 'this is not the time for young lawyers on training wheels" facetious remarks in St.Paul-please take note that our enemy is regrouping in Pakistan, and will certainly be profoundly encouraged by Obama's election. While the terminally idealistic like to think that appeasement, negotiation, diplomacy, & sanctions, all sound so very plausible-the simple fact remains that our enemy still thinks of us, Obama included, as "The Great Satan"...they have no intention of negotiating with Satan.
    In a word, we truly have lost the will to fight. And why not? With our iPods in our ears, our advancement to Boardwalk foremost in our minds, and busy painting our faces to attend the NFL game? We 'can't be bothered with the messy business of being at war'. As much as we would all like to close our eyes and 'cause it to disappear from view'...it ain't boys and girls! It just ain't. Nice try. I'm happy that you've found the moral high ground. Our enemy does not see you as standing on moral high ground...they see the egregious, unbridled greed that dragged the economy down the primrose path to the abyss we are 'enjoying now' - so we could all indulge our sopohmoric lusts for lots of 'stuff'. They see pornography and gambling on every corner, and the biggest customer for illicit drugs in the world...they feel a 'need' to destroy us.
    Thus I adjure everyone to focus on the final words of McCain's convention address...."Stand up and fight...stand up and fight...stand up and fight". Put it down, and step away from your iPods. We are at war. Remind yourselves that the dollar of 1965, when homes could be bought for $18K, is worth a dime today. Viewed from that perspective, this war is cheap. Remembering that more men were shot dead in a matter of hours at the Battle of the Bulge in WWII...this casualty rate is phenomenally low. Gird your trembling loins, and stand up and fight. OR...you could run home to mamaobama. "Protect me Daddy"...clue...h... ain't gonna protect you from anything. He's only one man. A young, idealistic, but inexperienced young man who stutters, and has a hard time finishing a sentience. he won't be able to finish anything.
    Reply
  •  
    Sep 07 09:55 PM
    The British won nearly every battle in OUR war of independence, but in the end they had to leave.

    We lost in Vietnam because we were on the wrong side from the beginning. In 1946, after fighting the Japanese in WW2, the Vietnamese declared their independence, in a document modeled on our own. We decided to support the French, who had been on their backs under Nazi rule for 4 years, retaking control of their colonies in Indochina. It took the Vietnamese 29 years to defeat the colonialists, first the French (we paid 90% of their costs; they just had to supply the bodies) and then the Americans. Not our finest hour. Not something we should repeat.

    The American public finally pulled the plug on a stupid and wasteful war that had always been based on lies (e.g., the Tonkin Gulf incident). We would never have "won" that war. The Vietnamese would have fought until we left, however long that took. We certainly did enough damage to both countries.
    Reply
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