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The defense investing cycle 1980 - 2010

|Includes: BA, GD, LLL, LMT, NOC, PowerShares Aerospace & Defense Portfolio ETF (PPA), RTN
If you are reading this, then you likely know how defense stocks have performed over the past decade and the issues they face today. You are also well aware that the markets overall are in turmoil and that defense stocks are likely in a holding pattern until the Congressional supercommittee comes back and we see what, if any, impact there is from their debt reduction efforts.
 
With this being the tenth anniversary of 9/11, from an investment perspective I found myself wanting to take a look back to the decades prior to 9-11so that I could hopefully draw parallels to the decline in defense stocks today. In particular I was curious to learn the following:
 
1. How big was the decline from peak to trough.
2. How long did it take to get from peak to trough; and
3. How long did stocks stay near the trough level before rebounding.
 
One can always talk about whether they think valuations are low or whether selling is overdone or still has a ways to go but I was hoping to find a historical analogy. The market tends to lead/lag so going strictly by defense budgets I knew wasn’t going to be the answer. It would mean finding index data for the defense build-up seen in the Reagan presidency, the collapse of the Soviet Union, the ‘peace dividend’ from Clinton’s first term and the start to rebuild it late in his second term, through 9-11. Data from 30 December 1997 through the present is readily available via the SPADE Defense Index (NYSE: DXS) but prior to that proved to be a problem. Data for the AMEX Defense Index (which the exchange uses for trading options) didn’t seem to go back much further according to the file they sent me. Expanding the SPADE Defense Index further back would be much too time consuming a task just to satisfy my curiosity as to do it right would mean identifying every public company that operated in the sector during that period including all mergers and acquisitions -- a task much too time consuming just to satisfy my curiosity.
 
So here’s the methodology I used -- from 1997 to 2010 the SPADE Defense Index is the source. Prior to this the data was a quick and dirty analysis using the ‘big 5’ prime contractors: Boeing, General Dynamics, Lockheed Martin, Northrop Grumman, and Raytheon (including their predecessor whose data was linked by CUSIP id’s). Two indexes – one equal weighted and one employing a simple modification based on the market cap weights we’ve seen over time. This data included dividends and price changes due to splits and other factors.
 
What I learned was the following:
 
Frequency of Downturns
There were very few negative periods during this entire time. Downturns took place in just three calendar periods: 1987, 2002, and 1980-1981. All other calendar year returns were positive.
 
The Investing Cycle
Looking at calendar returns from 1980-2010:
Down 2, Up 5 [decline of 14+%, prior to 1980, TBD]
Down 1, Up 14 [decline of 23.29%]
Down 1, Up 5 [decline of 2.87%]
Down 1, Up 2 [decline of 38.03%]
 
Ignoring the 3% decline as an anomaly, what appears is the sector can experience a severe downturn of 20% - 40% but, which during the first two cycles, rebounded to break even within four years from its bottom.
 
Correlations & Alpha vs. the S&P500
- Correlations were much lower in the 1980s and 1990s, almost independent of the market; whereas the late
2000s were highly correlated, a staple of the new market.
 
- Contrary to what is believed, compared to theS&P500, defense stocks outperformed in 1992-1996 (the Clinton presidency) and underperformed during the Reagan years (results skewed by a large selloff in
1987 and significant underperformance from 1985-1989). The sector for the 2000s outperformed the
market, most years by more than double digits, before peaking in October 2007 and tracking the market performance in 2008.
 
What Do I Think All This Mean?
1. Defense stock downturns can be severe but they don’t appear to last long. Historically, we are currently
at previous levels that define a bottom.
 
2. With dividends reinvested, within a few years investments can be reclaimed and long-term the defense sector has produced solid returns.
 
3. Investing in the S&P500 is MUCH more volatile than investing in the defense sector.
 
4. I’d like to see the results of a more detailed analysis that included large defense firms that were acquired including Martin Marietta, E-Systems, McDonnell Douglas, Loral Defense, Gumman, etc. as well as how world events, budget impacts, etc. impacted the stocks.
 
5. Still, with DoD restructuring how they are going to spend their budget, if I were investing I’d probably choose the Powershares ETF that tracks the SPADE Defense Index, (NYSE: PPA) to play an uptrend, get a dividend, without trying to figure out which companies will win in the current environment.
 
 
 
SPADE Defense Index (NYSE: DXS)
S&P 500 (ex-div)
2010
9.61%
12.78%
2009
21.71%
23.45%
2008
[38.03%}
[38.49%]
2007
22.17%
3.53%
2006
19.33%
13.62%
2005
5.30%
3.00%
2004
20.47%
8.99%
2003
37.27%
26.38%
2002
[2.87%]
[23.37%]
2001
0.94%
[13.04%]
2000
4.98%
[10.14%]
1999
15.31%
19.53%
1998
6.63%
26.67%
 
                               
 
Defense Stocks
(Equal Weight)
Defense Stocks
(Modified Weight)
S&P500
(reinvest div)
1997
14.84%
12.86%
33.36%
1996
22.21%
23.36%
22.96%
1995
60.83%
63.13%
37.58%
1994
5.21%
6.09%
1.32%
1993
44.62%
42.33%
10.08%
1992
16.02%
13.71%
7.62%
1991
12.60%
11.56%
30.47%
1990
6.52%
6.73%
[3.10%]
1989
5.23%
7.20%
31.69%
1988
9.03%
10.83%
16.61%
1987
[23.29%]
[24.19%]
5.25%
1986
8.89%
8.25%
18.67%
1985
14.51%
14.06%
31.73%
1984
12.43%
13.99%
6.27%
1983
12.55%
14.55%
22.56%
1982
39.46%
41.15%
21.55%
1981
[8.42%]
[7.96%]
[4.92%]
1980
[6.24%]
[6.71%]
32.50%
 
The above appears in the September 2011 "The SPADE Investor" newsletter, available on the author's website: www.spadeindex.com

The author manages the SPADE Defense Index and holds no positions in any of the stocks contained in the index or those mentioned in this article