There’s rabid demand for defense contracts and indicators this demand will keep growing
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Last week, venture capitalist Y Combinator—the money behind Twitch, DoorDash (DASH), and Dropbox (DBX) – began the backing of Ares Industries, a defense company that builds cruise missiles. Silicon Valley and the military historically go together like oil and water. But follow the money and it makes sense; the aerospace and defense sector are poised for robust growth in the next decade.
It’s a troubled topic, but the iShares U.S. Aerospace & Defense ETF (ITA) exchange-traded fund is up 43% since the onset of Russia’s invasion of Ukraine. Ironically, it’s up the same amount since the onset of the Hamas-led attack on Israel on Oct. 7. ITA’s top five holdings are General Electric Aerospace (NYSE:GE), RTX Corp (NYSE:RTX), Boeing Co (NYSE:BA), Lockheed Martin Corp (NYSE:LMT), and Northrop Grumman Corp (NYSE:NOC).
Per the chart below, only BA is in the red since February 2022, and that’s for other well-publicized reasons. The three other names, LMT, RTX, and NOC, all netted out record highs this week. (GE is not included due to its recent spinoff but is a healthy gainer as well.) However, note ITA’s 14-Day Relative Strength Index (RSI), sitting on the cusp of overbought at 69, the highest level since late May. You can also see that any trips above 70 usually result in ITA turning lower on the charts. The individual RSI’s of LMT, RTX, and NOC are even higher, last seen at 72, 88, and 85, respectively.
Despite the overbought nature of the sector, there remains some short-term intrigue. Per Senior Quantitative Analyst Rocky White, NOC averages a 1% move in September over the last 10 years, with a monthly win rate of 70%. Beyond the big five, Heico Corp (NYSE:HEI) traded as low as $230 on Tuesday after a second-quarter revenue miss, but pared losses that day to finish marginally lower then promptly filled that gap and rallied to a record high of $259.04 by Friday. That type of resiliency should set off alarm bells. Kratos Defense & Security Solutions Inc (NASDAQ:KTOS) flashed a bullish combination of affordable premium and multi-year highs earlier in the week and responded with another multi-year high on Thursday.
AeroVironment Inc (NASDAQ:AVAV) reports earnings after the close on Wednesday. AVAV has a history of outsized post-earnings reactions, including a 27.9% pop back on March 3, and a 20.7% breakout a year ago. For next Thursday’s trading, the options market is pricing in a post-earnings move of 9.7%.
Longer term, the numbers show money being piled into the defense sector. Per Stimson Research, the U.S. Department of Defense requested a budget of $850 billion for fiscal 2025. defense spending has increased more than 48% in just the first 24 years of this century, adjusted for inflation.
According to the Stockholm International Peace Research Institute (SPRI) think tank, there have been nine consecutive years of increases, with last year’s gain of 6.8% the highest level ever recorded. U.S. European Command’s top official spoke earlier in the month about the need for industrial bases to evolve to meet the type of large-scale conflicts in Ukraine. Senator Roger Wicker (R-MS) released a report in May 2024 calling for a “generational investment to revitalize our armed forces” by raising defense spending to 5% of the Gross Domestic Product. It is currently only 3.5% in 2024, per Statista.
Factor in the artificial intelligence (AI) advancements that will be harnessed and integrated, plus Silicon Valley’s recent interest, and it’s safe to assume the money won’t be drying up for defense anytime soon.
It’s not just stateside; SPRI notes that China increased its military budget by 6% to $296 billion in 2023, while Japan and Taiwan swelled their budgets by 11% apiece. Per a Washington Post article back in February, global military spending hit $2.2 trillion in 2023. With all this demand, are defense companies able to keep up with their supply?
The key word to monitor is backlogs, inventory that has been ordered and therefore technically spoken for but has not been shipped yet. Lockheed Martin’s backlog is nearly two times its revenue. RTX’s backlog increased year-over-year, while General Dynamics (GD) reported a record backlog. AeroVironment’s $1 billion contract with the U.S. Army announced last week will boost its own backlog. In other words, many of the defense sectors top names are answering the call to all this rabid demand. With all of these macro tailwinds swirling throughout the defense sector, it makes short-term relative strength concerns much more palatable.