Are Defense Sector ETFs A Post-Sequester Bargain?

Includes: ITA, PPA, SPY
by: Gary Gordon

The closest thing to bipartisanship in the presidency of Barack Obama may have happened a few weeks ago. Eight prominent Senators -- four Democrats and four Republicans -- have been crafting an immigration reform bill that many believe could eventually become law. However, finding common ground on economic issues has eluded members of Congress for years. The Senate hasn't passed a budget since 2009. And with the exception of an 11th-hour tax rate hike in the fiscal cliff conversations, nearly every major financial decision has been an exercise in delay.

Most notably, in early July 2011, Republicans did not want to agree to raising the country's debt limits without corresponding spending cuts. Democrats did not want to agree to spending cuts to social programs, and strongly preferred tax hikes to lower the ever-increasing public debt. Due in large part to the partisan wrangling, U.S. stocks declined roughly 20% from their intrayear peaks. It wasn't until August 2011 that both sides agreed to an enforcement mechanism (aka, "the sequester") for an eventual deficit reduction package; that is, come up with a bipartisan bill that will pass or accept across-the-board cuts, half of which will be in the arena of "non-essential" defense spending.

Deadline after deadline passed without consequence. Even the Jan. 2, 2013, date for sequestration had been pushed back to March 1. And as far as anyone can tell, there has been no bipartisan bill for cutting $1.2 trillion from the deficit over time. It follows that scores of market-watchers, analysts, and economists expect Democrats and Republicans to let the automatic cuts go into effect. Specifically, the government will cut $600 billion from defense and another $600 billion from other government "faves." (Note: Major social programs like Social Security are not part of the equation.)

The curious questions that naturally result include: 1) Will leaders come up with another 11th-hour postponement?, 2) Will the stock market tumble if they don't?, and 3) Are defense sector stocks particularly vulnerable?

I am neither a political insider nor a clairvoyant. Yet I do have opinions on likely outcomes. Regarding the first question, you should not expect another 11th-hour deal. Leaders from both parties will let the automatic spending cuts go into effect.

Politicians -- U.S. politicians, in particular -- are not feeling enough pressure from citizens nor peers to come to an an arrangement. Moreover, Republicans genuinely believe that out-of-control spending is the issue requiring action, whereas Democrats genuinely believe that more revenue via taxation is a better prescription and that government spending is necessary to keep the economy on track. Disparate philosophies and a lack of urgency when stocks are near all-time highs suggest that sequestration's automatic cuts will occur.

How will the stock market react? Until now, stocks have acted with indifference to harmful realities and real possibilities with respect to economic growth. In some instances, the markets even celebrate bad news, since it often implies that the Federal Reserve will need to stay its course of intervening in the bond markets to keep rates artificially low. Nevertheless, I expect profit taking -- and I expect it to be sharp. A correction of 5% may occur in a matter of a few weeks. (Note: Stock markets frequently give back half of a recent uptrend, and that is what I anticipate.)

The final question, then: How might defense corporations fare when sequestration kicks in and stocks pull back? PowerShares Aerospace and Defense Portfoflio (NYSEARCA:PPA) and iShares DJ Aerospace and Defense (BATS:ITA) are not immune to sell-offs. Indeed, they will fall as much as the market -- and probably a bit more.

Both PPA and ITA fell more than the S&P 500 in the week that followed the general election, as investors worried about a fiscal cliff calamity. The exchange-traded trackers rallied back nicely with the rest of the market, as progress seemed to occur. However, in 2013, the PPA:SPY price ratio demonstrates that the relative strength of the defense sector is weakening. This may largely be attributed to apprehension about imminent cuts to defense spending.

By the same token, the investment community has been champing at the bit to buy the proverbial dips. Corrections may be short-lived, if for no other reason that inaction on the part of congressional leaders may translate into continued stimulus from the Federal Reserve.

The sell-off in PPA and ITA may be harsher and more severe than the market at large, but it may also provide trend-followers with an opportunistic purchase. If you see an opportunity to get PPA at a price that is 10% lower than it is today, you might benefit by seizing the day. As always, use a stop-limit loss order to minimize the risk of continued selling pressure.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.