With the election looming over the economy, more industries are being tormented by inaction and political bickering. The market sentiment is becoming increasingly frustrated due to the lack of a stable regulatory environment. This instability makes it very difficult to determine a long-term investment strategy. After all, how can you forecast corporate earnings if you don’t know what the politicians will do in a few months?
One sector that is warning of huge problems and a hit to corporate earnings is the military. While I wrote about this topic briefly over a month ago in the article Deep Budget Cuts to Hurt this Sector, we just heard from the Pentagon itself that, unless the politicians can strike a deal to reduce the budget deficit, the automatic cuts are going to be very deep and firms need to start preparing for hits to their corporate earnings as a real possibility.
Corporate earnings of firms that supply military equipment are at the mercy of politicians and that can keep someone awake at night. To define an investment strategy based on the number of votes this fall is extremely difficult. This is one reason that leaders of defense firms are speaking up and making politicians aware that the job cuts and plant closures will be very severe.
Before we even get to the budget cuts, many companies are worried that the Pentagon is withholding the making of any new decisions and purchases ahead of this event. This will certainly hurt corporate earnings on the margin, especially for small firms whose primary customer is the Pentagon. Inaction and a lack of visibility for corporate earnings certainly won’t improve the market sentiment in this sector.
Unless politicians vote to override the automatic cuts, the defense budget is scheduled for an automatic reduction of $50.0 billion, which will hurt corporate earnings throughout this sector. Out of the $531 billion currently allotted to defense, the cuts equate to approximately 10%. This is a huge amount, especially for an economy that is barely growing at all. Roughly one million people work in this industry. Aerospace Industries Association estimates that the defense sector, including primary companies and suppliers, would lose approximately 350,000 jobs, as companies try to retain their corporate earnings. It is difficult to make an investment strategy when so many people are going to be hit by these cuts, if they don’t get overridden.
One of the bigger suppliers is Lockheed Martin Corporation (NYSE/LMT). This is a big firm and it certainly won’t be disappearing, but, after the huge run-up since the fall of 2011 from $66.00 to $91.00 currently, I would certainly be taking profits off the table. The firm has a very high level of debt/equity and the firm is relying heavily on the “F-35” jet fighter. There have even been a few cracks on the jet fighter front, as Canada might not be purchasing $25.0 billion worth of planes. The country’s auditor general stated that the purchase was conducted without fair competition and the costs are too high. With austerity and budget cuts in vogue around the world, selling such a high-priced plane might be more difficult than expected. If the market sentiment is expecting a massive move up in corporate earnings for Lockheed, combining canceled sales with massive defense budget cuts and the stock is being set up for a fall.
The key to a solid investment strategy is moving one way when the market sentiment is still moving the other way. Defense stocks have done extremely well and I’m not advocating shorting them, as there is too much uncertainty regarding corporate earnings in every direction. I think that’s the key; with this much uncertainty, developing an investment strategy will be extremely difficult when you have to rely on politicians to do the right thing. They will pander to their constituents, instead of doing what’s right for the entire nation. The market sentiment will soon shift, I believe, as this uncertainty becomes more pronounced and corporate earnings will be hurt until more clarity is evident.