Could Be Mayday for the Defense Space

 | Jan 06, 2012 | 12:00 PM EST
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This commentary originally appeared Jan. 6 at 9:45 a.m. EST on ETF Profits -- to access all the strategies from our team of ETF professionals, click here

In a time of general economic uncertainty, there are a few things we know for certain. One is that Washington's debt balance is continuing to grow -- and another is that the current situation isn't sustainable. The not-so-distant future is near certain to hold either significant tax increases or drastic spending cuts, or both. Amid this, it appears increasingly likely that the defense sector will be on the chopping block, and that it will be perhaps the biggest loser from last 12 months' political developments -- or, shall I say, political theater.

For the past several years, aerospace and defense stocks have been something of a safe haven for investors. Even in the midst of extreme chaos in the market, demand for these products and services remained relatively stable. Two large overseas conflict will do that. As wars in Afghanistan and Iraq continued for longer than many had anticipated, firms manufacturing everything from weapons to helicopters have reaped a nice windfall.

As a result, the iShares Dow Jones U.S. Aerospace & Defense Index Fund (ITA) has gained about 50% total over the last three years, and managed to deliver a return of about 20% over the last five. For those of you keeping score at home, the S&P 500 is virtually flat for the last five years. 

Now, though, it appears as if the boom period is drawing quickly to a close. The Joint Select Committee on Deficit Reduction, or "Super Committee," failed to reach an agreement late last year, so the Defense Department is facing up to $600 billion in cuts over the next decade. That's on top of a $450 billion spending cut previously levied.

That already grim scenario for the industry got even worse Thursday, when President Obama announced plans for a "leaner" military that will utilize smaller conventional ground forces. It's unclear exactly what the change in strategy will entail, but it's fairly safe to assume that this will not be a positive development for the defense sector.

So, in short, the current environment has become a very challenging one for companies that make equipment used by the U.S. military. The winding-down of the war in Iraq, pending slashes to Defense Department spending and strategic military shifts make it unlikely that ETFs such as ITA will continue their impressive run. As the downward pressure continues to build, an opportunity appears to be developing here for those with the stomach to short.

One strategy that I like involves a short position in ITA, which consists of stocks such as Boeing (BA), Lockheed Martin (LMT) and Northrop Grumman (NOC), coupled with an equal long position in the Industrial Select Sector SPDR (XLI). The result is market neutral exposure: Both funds cover the U.S. industrials sector, but ITA specifically targets the challenge-ridden defense component of that space. If the defense cuts ahead weigh on ITA, as I suspect they will, this trade could be an effective way to generate alpha without taking on considerable volatility.

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