The following is the author's commentary that appears in the September 2009 issue of "The SPADE Investor".

The Chase for Ten

Historically, aerospace and defense cycles can run 12-15 years. And for nine years running, the SPADE Defense Index has outperformed the broader markets. Even after huge gains by financial stocks since the March market bottom, defense stocks trailed the S&P 500 by just 3.5%at the end of August but have been making up ground lately.

The SPADE Defense Index (DXS) continues to trend upward in spite of the five largest defense companies contributing subpar performance year-to-date.

Since what is referred to as the “Haynes bottom,” after CNBC host Mark Haynes’ call of a market bottom in March 2009, the SPADE Defense Index is up more than 44%. For the market chartist, the SPADE Defense Index has broken out from its moving averages.

Both the SPADE Defense Index and the S&P 500 ended the month flat, holding on to large quarterly gains, which saw the sector rebound by more than 17% in the quarter and 37.6% from the market lows in March. Early gains in June were offset with declines following Boeing’s (BA) announcement of further delays in the 787 program -- an issue which has been a drag on the sector for the past year. Progress toward testing, first flights, and a firm delivery date should provide a boost to the sector as the program moves from R&D into manufacturing; enabling firms across the sector to post revenues.

The impact of the Department of Defense’s program restructuring and cancellations that were contained in the FY-10 budget has proved to be more minimal than many originally feared. As anticipated, new opportunities have supplanted those that have been cancelled. While all parties -- companies, analysts, investors -- recognize that growth in the U.S. defense budget has likely peaked, numerous opportunities remain and are being identified.

Specifics of the FY2010 Defense Department budget were finally made available in early May and there were few surprises from the information that was leaked over the previous weeks. A number of large programs were cancelled or scaled back including major initiatives such as the Future Combat System, Transformational Satellite TSAT, and the presidential helicopter, but each were “replaced” with other programs that are designed to meet the ongoing needs of the agency. In fact, despite the cancellation of the multi-billion TSAT program, spending on new communications satellites in FY10 rose.

Analysts have now shifted their attention toward gathering information on the 2010 Quadrennial Defense Review (QDR) which will be the guide for the FY-2011 to FY-2015 budgets -- although final details are not due until next February. While a number of analysts think defense spending has peaked with the FY-10 budget, dramatic cuts in future budgets is meeting with resistance from a number of current and former members of the executive branch and Congress as well as military officials.

Although the industry got a teaser of what’s to come when Defense Secretary Gates announced the top line budget figure as well as some decisions regarding the fate of the largest programs and initiatives, the key event that will guide the sector’s performance over the next several months is the release of the line item details and program specifics found in the FY10 budget -- anticipated to provide specifics not just for the forthcoming year but the next several. These details are now expected, according to White House sources, sometime in May.

Overall, analysts have stated that there were no big downside surprises in the proposal and the shift in priorities had little impact on most firms. As we said last month, we needed to see whether additions in some programs would offset declines in others. Lockheed Martin (LMT) for example was seen as one of the big winners and big losers with the F-22 production begin shut down while the F-35 was expanded.

The key event that will shape the defense sector for the next year and beyond is when details of the defense budget are released in April (though we are hearing unconfirmed rumors that it could slip into May). While I could add to the budget speculation without any concrete information, instead I’ve decided to focus this commentary on...Clint Eastwood. Not because many of his characters stand for justice, truth, security, or that his gruff onscreen warrior persona is stereotypical of America’s soldiers out to fight the good fight, what comes to mind is the title of one of his movies, “The Good, the Bad, and the Ugly”. What better phrase can summarize what goes through the mind of an investment analyst focused on the defense sector these days.

Although the SPADE Defense Index beat the S&P500 for the ninth consecutive year in 2008, it was still down 36% and since January’s gains, the sector hasn’t fared very well in the market. So when I see that we are 50% below the Index’s high of last October, ugly comes to mind.

After starting the year off with strength as compared to the broader markets, the defense and security sector slid significantly in February posting one of its worst one-month returns. Whereas in January, when the SPADE Defense Index outperformed the markets by better than 5%, February saw the sector give it all back. The Top 10 laggards for the month included three of the sector’s largest firms with Boeing (BA), Lockheed Martin (LMT), and General Dynamics (GD) all losing more than 20% of their value.

Meanwhile, the sector’s price-to-earnings and price-to-book ratios are at a level usually seen after the sector has undergone a significant downturn in defense spending leading some to wonder if the sector has already priced in budget declines years in advance and hence, open up the possibility for upward action.

2009 is shaping up as a year of both challenges and opportunities for the defense sector; although after the stock market downturn in late 2008 the same could probably be said about many sectors.

After narrowly outperforming the S&P500 on a price basis for the 9th consecutive year, the SPADE Defense Index finally diverged from the market in January, and although it ends January down 3%, it is 5.5% ahead of the S&P500.

First of all, congratulations to FLIR for being added to the S&P 500.

Secondly, although it was a brutal year for investors, hats off to the Defense Index’s Top 10 2008 performers, each of which ended the year in positive territory and the top six which were up more than 30%. Two have been acquired (DRS and SI International), four operate in the C4ISR/IT space (NCI (NCIT), Mantech, SI International, Stanley (SXE)), three in homeland security (Cogent (COGT), American Science & Engineering (ASEI), Axsys (AXYS)) and one in UAVs (Aerovironment).

Although November ended on an upbeat, overall the month was brutal for stocks and the defense sector was no different. The sector has not been trading on fundamentals or the realization that defense sector revenues and earnings are relatively independent of recession, instead following the broader markets (see chart).

click to enlarge image

As anticipated, Barack Obama won the election for the White House and will take the office of President of the United States on 20 January 2009. With the election settled, it is time for us to turn our focus toward the impact that this new administration will have on the defense sector considering our anticipated withdrawal from Iraq, budgetary pressures from a weakening economy, and the costs associated with a revamped finance and banking system.

Instead of speculation, here is what we know based on comments made during the campaign by President-elect Obama, his campaign officials, and supporters.

The massive global sell-off in, well, everything, continues to impact investments made in the aerospace, defense, and homeland security sector.

With the market operating in uncharted territories, I’m now hearing commentators refer to the Panic of 1907 as the only corollary, it is hard to near impossible to provide a commentary that the market will bear out. With gyrations that can influence prices 5%, 10%, 20% in a single day without reasons other than the fear that has entered the market, discussing the underlying fundamentals almost seems trivial.

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.

Since the SPADE Defense Index  [Amex: DXS] peaked in October 2007, the aerospace and defense sector has been stuck in bear market territory for the past several months. It is a situation that has had more to do with broader stock market issues and perceptions of what will or what might happen to the sector a year or several years out than any specific business issue facing the sector today.

In fact, recent quarterly earnings posted by many of the sector’s companies have been positive, and in some cases show significant gains in revenues and earnings. Conversations with many firms at the recent Farnborough Air Show indicated strength in current and nearterm operations as they try to fill an ever increasing backlog of business.

In this month’s commentary, there are two trends I’d like to address, the second quarter rise in defense stocks, and a tip of the hat to...ourselves.

Merger Mania & Defense Supplier Base

The following interview with Lockheed Martin (LMT) CEO Robert Stevens was conducted on April 25, 2008*.

Surprised by title of this month’s SPADE Investor commentary? Well you are not alone.

Typically, I’ve tended to take a broader, longer-term view of the trends driving the aerospace and defense sector, but today I’m going to primarily focus on the short-term and statistics that many investors and financial analysts track.

The past three months have seen several newsworthy items of importance to the defense sector which were covered by the media and then which quickly faded from discussion. Even in the heat of a political campaign season, the release of the defense budget was greeted by politicians, who then quickly moved onto another topic. This is either an indication that they may all be in quiet agreement on the importance of defense or the realization that you cannot advocate reducing the defense budget and expect to win an election.

The Ten Most Asked Questions by Investors

(in no particular order)

With the major U.S. market indexes all down for the fourth consecutive month, one might see this play on the Alan Greenspan speech in 1996 as an interesting choice of words. Back then, before the height of what has become known as the Internet bubble or the Tech bubble, the market seemed to favor all sectors and styles. Although some more than others, it was hard to identify an investment strategy that didn't work.

Today, we have the opposite, with nearly every equity sector and style seeing weakness driven by the serious economic issues in play at the moment: recession, inflation, the housing/ bank/ loan crisis, and a weak dollar. Recent conversations with money managers, and analysts that monitor the economy and Wall Street, have said that its possible that problems may be even worse than many people realize as capital for investment moves to the sidelines. Where the mood in the irrational exuberance days was 'everything is wonderful' (even in areas where it wasn't) today the mood is 'everything is horrific', even in places where it isn't.

Although analysts in December and throughout January said that aerospace and defense were a favored sector in 2008, investors took the opportunity to sell into the eight-year rally. Before the month was over, the Fed discounted interest rates twice to stabilize a market that drifted (or should I say shot) past a 10% correction passing the 20% level indicating a bear market. The defense sector was no exception as the SPADE Defense Index, dropped 21.23% from its peak on November 6th to its January 23rd low. But with a rally in the final 7 days of January, the index rebounded more than 10.6 % taking us to levels originally passed in May 2007.

What was surprising is that a sector favored by analysts and that, honestly, did not have any great news attached to it that would change the forecast, wouldn’t just see a sell-off in some individual stocks but in the ETF tracking the sector as well. The carnage saw a drop of 4 million shares or 22% of the investments in the fund from its peak. The fund began to rise again with creation units added on the 31 January. Overall, the ETF saw record-high monthly volume of nearly 7 million shares.