When you've given up on the world, gold looks like a good investment. But if your outlook is merely bleak, then defence stocks look like a better bet.
Defence, of course, is a euphemism. What we're really talking about here are companies that make bullets, bombs and rockets, which hold particular appeal when global violence is on the rise – or, to be more precise, when the U.S. military is gearing up for action.
Stocks such as Northrop Grumman Corp., Lockheed Martin Corp. and Raytheon Co. captured the imagination of investors shortly after the devastation of 9/11, when the United States embarked upon a long-term war against terrorists.
These stocks are rallying again as the world takes another dangerous turn. Russia's belligerence toward Ukraine has everyone on edge. But the U.S. military's attempt to roll back the Islamic State – the ruthless Sunni militant group that has taken over large swaths of Syria and Iraq, while executing prisoners, aid workers and journalists – is considerably hotter.
U.S. President Barack Obama has won strong bipartisan support from Congress to arm moderate Syrian rebels, in addition to launching air strikes against targets in Iraq as part of a co-ordinated effort with Iraqi forces and other allies.
This isn't likely to be a quick mission. The chairman of the U.S. Joint Chiefs of Staff described one phase as "extraordinarily complex." And Mr. Obama's plan to "degrade and ultimately defeat" the enemy sounds like a long-term goal, if not the start of some sort of mission creep.
The seemingly endless violence is giving defence stocks a big lift as investors pile on. Many stocks hit record highs this week, and some strategists remain bullish on the sector.
Don Coxe, chairman of Coxe Advisors in Chicago, said in a note: "At a time when valuation of economy-related U.S. stocks are stretched, the major munitions companies suddenly look very attractive."
David Rosenberg, chief economist and strategist at Toronto-based Gluskin Sheff + Associates, has been making a similar observation in recent months, arguing this week that defence stocks are a natural bet when global instability is on the rise.
Defence stocks have more than instability going for them, though. As the Cold War was winding down in the late 1980s, Mr. Rosenberg noted, military spending represented more than 5 per cent of global gross domestic product. The share had slipped to just 2.3 per cent at the end of 2013, implying a trough.
In other words, military spending really only has one direction to go: Up.
In the meantime, earnings growth among some of the key players within the defence sector is already impressive. According to S&P Capital IQ, Alliant Techsystems Inc. should see its earnings rise more than 40 per cent by 2015, from 2010. Raytheon's earnings are expected to rise 45 per cent over a similar period. Northrop Grumman's earnings have been rising 23 per cent a year, over the past five years.
Dividends are also attractive, averaging about 2 per cent. Last year, Lockheed Martin boosted its cash payout by 16 per cent, and the company has more than doubled the payout over the past five years.
It's true, defence stocks have already enjoyed an impressive rally. The SPDR S&P Aerospace & Defense ETF, an exchange-traded fund that provides broad exposure to the sector, has risen more than 28 per cent over the past year, to the end of August.
However, valuations aren't particularly stretched. The average price-to-earnings ratio is about 17, which looks quite reasonable, given the sector's earnings growth and the prospect of rising military spending.
Hey, and if things don't work out, at least you'll be enjoying something arguably far more rewarding than investment gains: World peace.