Deep Budget Cuts to Hurt this Sector

credit crisisWith the recent report from the Congressional Budget Office (CBO), there were several key areas that will affect corporate earnings for an important market sector: defense stocks. When an investor looks for long-term stocks to put their money to work in a specific market sector, understanding the growth potential for corporate earnings over the next five to 10 years is very important.

The CBO announced that its estimate of defense spending will drop from 4.6% of GDP in 2011 to 2.76% in 2018. According to Bloomberg, in real terms, this would be a larger decline than what followed the end of the Cold War in 1989. At that point, defense spending dropped from 5.6% of GDP in 1989 to 2.95% in 1999. This is a substantial hit to any market sector.

With the rising budget deficits, spending cuts have to come in one form or another. These cuts occurring in a relatively weak economy can really hit corporate earnings in this market sector, as well as other related industries.

These estimates are obviously predicated on the assumption that no new wars will be started. Yes, we do have Iran, but, as is evident from recent comments coming out of the White House, this administration does not want another heavy involvement in yet another way. A few bunker busting bombs, fine, but a long protracted war? Not likely. This reluctance to use the military and the ending of battles on several fronts, like Iraq, will continue to hurt this market sector and the corporate earnings of companies related to it.

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While I’m not advocating going short this sector immediately, I do want to offer a cautionary note to be careful when looking at a market sector from a purely “cheap” valuation point of view. Just looking at the current crop of corporate earnings is not enough. One must look out over a period of time in a market sector to see what’s on the horizon, since the corporate earnings portion of the price-earnings ratio might decline substantially.

Lockheed Martin Corporation (NYSE/LMT) is a giant within this market sector. The company has its hands in many areas of government spending and this has driven corporate earnings for many years. While on some metrics the stock appears fairly valued and has a good dividend yield, if someone wanted capital appreciation, I’d suggest looking elsewhere, as there doesn’t appear to be much upside left.

With the dark clouds of budget cuts from one of your biggest customers (the U.S.government) and with most of the major wars over with, this market sector could be in for a slow grind down over the next decade. I’d also look at your portfolio for suppliers to the defense market sector, as some of those corporate earnings could be hurt over this next decade. Understanding where a market sector generates revenue and who the end customers are is crucial to getting a better handle on where corporate earnings growth is going to come from. I’d always be wary of investing a lot of money in a market sector where corporate earnings are forecast to decline over the near future.