Defense ETFs May Advance on World Tensions

October 21, 2022

The iShares US Aerospace & Defense ETF (ITA) has outpaced the S&P 500 this year, and world events point to a continuation in coming months and years. 

For an explanation, we turn to the experiences of Art Cashin, the director of floor operations at the New York Stock Exchange for UBS Financial Services Art. He has seen it all over his six decades in the industry—bull markets, bear markets and conditions where volatility evaporated and following share prices was like watching paint dry.   

Early in his career, Cashin learned a valuable lesson. From Oct. 16-29, 1962, the U.S. and Russia faced off during the Cuban Missile Crisis, and fears of nuclear war grew. At the peak of the crisis, rumors flew that missiles had been launched. New York Stock Exchange traders aggressively sold, and Cashin followed the flow.  

A mentor explained: “When you hear the missiles are flying, you buy them; you don’t sell them. You buy them because, if you’re wrong, the trade will never clear. We’ll all be dead!” The bottom line: If the nuclear conflict never occurs, the relief rally will be explosive, as the sellers scramble to cover short positions.  

Russia, Ukraine 

With Russia threatening to use tactical nuclear weapons in Ukraine and cautioning the U.S. and NATO that they could be in their crosshairs if they continue their support, the fear of nuclear conflict is again rising.  

Meanwhile, the first major war in Europe since World War II comes as inflation is raging, central banks are pushing interest rates higher and U.S. political division is soaring ahead of the November midterm elections.  

While the current landscape is bearish for the stock market, Cashin’s lesson from 60 years ago should be remembered. 

MAD: Keeping the Peace? 

Mutually assured destruction is why the world’s nuclear powers haven’t used the weapons since the U.S. dropped them on Japan in World War II. When the Berlin Wall fell in late 1989, “MAD” nearly disappeared from the worldwide vernacular.  

It seems to be back, thanks to Russia’s invasion of Ukraine and China’s designs on reunification with Taiwan. The potential for nuclear conflict has frightened the world, and markets move on greed and fear. Meanwhile, threats won’t spark a nuclear war because the world’s powers seek control, and destroying the planet runs contrary to that end.  

Geopolitical Bifurcation 

While all-out nuclear war is unlikely, other tensions are making governments nervous and may spark arms purchases.  

The February handshake between China’s President Jinping and Russian President Putin at the Beijing Winter Olympics heightened geopolitical bifurcation as the leaders agreed on “no-limits” cooperation. Only weeks after the ceremonial handshake, Russia invaded Ukraine, increasing fears that the alliance would accelerate Chinese plans for forcing a reunification between mainland China and Taiwan.  

The world is again dividing between allies and axis—China, Russia, Iran and North Korea on one side, the U.S., Europe, Japan, Canada, Australia and their allies on the other—threatens world peace and safety.  

The war in Ukraine is on Germany’s doorstep, and Chinese aggression and North Korean missile tests in Asia pose an existential threat to Japan. After WW II, Germany and Japan demilitarized, and in 2022, that era is ending. Geopolitical tensions will likely lead to a substantial military buildup, with defense contractors set to reap the benefits.  

 

ITA's Top 10 Holdings

Source: Barchart 

 

At $95.59 per share on Oct. 17, ITA had over $3.5 billion in assets under management. ITA trades an average of nearly 400,000 shares daily and charges a 0.39% management fee. The blended dividend yield of .98 per share or 1.02% more than covers the expense ratio for medium- to long-term holders.  

ITA Trend Points Higher 

At the 3,680 level, the S&P 500, the most diversified U.S. stock market index dramatically declined in 2022.

 

Source: Barchart 

 

The chart shows that the S&P 500 was 22.8% lower than the 2021 closing level on Oct. 17, 2022.  

 

Source: Barchart 

 

Meanwhile, ITA closed 2021 at $102.78 per share. At $95.59, it has outperformed the S&P 500 as of Oct. 17, with a 7.5% loss.  

The geopolitical landscape favors earnings for the leading defense contractors as the business will likely boom over the coming years. MAD will prevent global nuclear war, but conventional military buildups point to higher highs for ITA and the defense sector.  

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