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I must say as someone who has followed Washington very closely as an attorney and political activist I’ve never seen such a bad yet misunderstood piece of legislation affect the market as the debt ceiling bill. Apart from the nonexistent cuts that the bill is going to appoint a bipartisan commission to address (like the Bowles-Simpson commission that almost got its recommendations half way to first base) the fact that this commission is supposed to recommend possible spending cuts or a raise in taxes - or the elimination of deductions – in an election year should not lead us to have much confidence in what, if any, large actions will be recommended over the twelve month period.

Depending on the day, this bill has been portrayed as a job killing revenue cutter by many on the left, and the bill that changed the culture of Washington by the right. While the long-term importance of the bill is up for debate the price action in the market has been decisive and negative. Without question, the one sector that has been most heavily battered by the debt debate punctuated with the brutal near-300 point decline Monday after the Senate approved the final version of the bill, is the defense sector.

Even companies that had good earning reports like Lockheed Martin (NYSE:LMT) and companies that have less exposure to larger contracts that theoretically would be likely to be the first to be cut like Northrop Grumman (NYSE:NOC) have been sold off between 15%-20% on average. What is interesting about this sell-off, which seems to be institutional shorting as both stocks have very high short interests with Northrop Grumman having a nearly 10% short interest, is that it's obviously not predicated on economic weakness. These companies had strong earning reports even in 2007, a year when the government took in far less revenue than it will this year, and this shows that these companies' earnings capability are not really tied to the economic cycles. These companies have lost 20% of their market cap primarily if not solely because of the belief that the Pentagon budget will be reduced by 10%-20% over the next several years by the “super” commission that is mandated to make sure new spending doesn‘t increase the current debt levels at 14 trillion over the next several years. These stocks have been so heavily battered that Northrop Grumman now trades at 8x next year's average earnings estimate with a book value just over 1 and a price-to-sales ratio of .5.

Now the last time the defense sector sold off hard was after the 2008 election when everyone was convinced Obama would massively cut defense spending across the board and immediately begin to withdraw troops from both Iraq and Afghanistan. Obama instead waited over a year to make any withdrawals in Iraq while massively increasing American troop deployments in Afghanistan and actually increasing the defense budget even with a Democratic congress. Business went on as usual and these stocks rallied nearly 30%-40% over the next two years. Obama has even strongly resisted calls from even the left in his own party to end the War in Afghanistan or make significant cut in long-term Pentagon projects.

These companies have lost a fifth of their market caps solely because we are now to believe that the massive defense cuts of 10%-20% (over several years with cuts of the roughly 600 billion dollar Pentagon budget suppose to be just 25-30 billion this year) are coming to a defense budget of over half a trillion. It's important to look a little closer at the actual substance of the debt ceiling bill (or lack of it). The “super” commission that is mandated to ensure future spending will not increase the debt will have an equal number of Democrats and Republicans on it, each appointed by their respective leaders in the House and Senate, and will recommend some combination of ways to increase revenue and cut spending to ensure that our debt stays around the current 13-14 trillion level.

A couple points. First, a cut in Washington means that spending can’t increase from the historically high level of nearly 20% of GDP (historically we’ve been at 4-6%). Second, the Republicans are open to closing deductions and actually asked for a raise in defense spending during the debt debate, but they almost definitely won‘t vote to raise taxes and certainly wouldn't vote to do so in an election year. Republicans don’t mind increasing government revenue by closing loopholes as long as they can say they didn’t “raise” taxes, but are not open to big defense cuts, certainly not ones of large significance, and in fact want to increase the size of the Pentagon‘s budget. Even the comments by leading Republicans on the Senate Armed Service committee who control the Pentagon’s budget, Senators McCain and McConnell, seemed to think that cuts in defense spending were unlikely, though the consensus for the 2012 budget is a massive cut of 28 billion – a roughly 3% reduction in a 600 billion dollar budget. Leaders of both parties have said that they are not aware of any specific cuts in defense spending in the current debt ceiling bill and that they in fact expect defense spending to be similar if not higher than last year in the current budget. Senator McConnell’s comments were particularly telling as he’s responsible for appointing a fourth of the members to this so-called super commission and is the Republic Senate leader.

So why this talk of massive or even substantive cuts in defense; where’s it coming from? The reason hedge funds and other people shorting the defense industry are getting away with killing these stocks during and in the immediate aftermath of the debt debate is that this legislation is very vague even by Washington standards. The bill outlines not one spending cut whatsoever and instead imposes a suspect and equally vague trigger that would somehow magically cut spending by 10% even if congress can’t agree on spending cuts or revenue raises. Now call me crazy, but given that the Republicans “won” the debate by getting bigger spending cuts than the Democrats were willing to concede without raising taxes or closing corporate loopholes, I don’t see them massively cutting defense spending in an election year three months after delaying a debt ceiling deal for nearly a week in part because they wanted to see an increase in the Pentagon’s budget.

Now, to conclude, there could be some cuts in defense spending, but I heavily doubt anything massive. But, even if that’s the case a 20% sell-off is excessive and for companies like Northrop Grumman and Raytheon (NYSE:RTN) that don’t have the larger long-term contracts, it seems excessive. So a 600 billion dollar budget goes to between $500-$550 billion; that’s not reason for these stocks to sell off 20% give that many already suspected the defense budget would be coming down modestly with the wars in Iraq and Afghanistan winding down and many had already factored that into the companies' share prices. Betting that Washington won’t significantly cut defense or entitlement spending is usually a safe bet, and in an election year it should be even safer than usual.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: The Defense Sector: Heavily Oversold and Highly Misunderstood