The Xchange Blog

Is the Best Offense Still a Good Defense?

Despite having entered another phase of tariffs and counter-tariffs, the U.S. stock market has remained resilient, and traders have kept their nerve while two of the world’s largest economies exchange blows. Even though the sustained uptrend in the broad market has surprised some, the truly astonishing thing is that it is doing so without the help of traditional leaders like tech, internet and semiconductor stocks, most of which are down as a result of aforementioned trade fears. Instead, the market has found a few surprising sectors, like healthcare and utilities, to drive the market in the waning months of 2018.

Perhaps the most surprising market sector to lead the S&P 500 are the industrial industries, which have pushed the Industrial Select Sector Index up 7.5 percent over the past 3 months.

 

DUSL vs. S&P Industrials Select Sector Index (IXITR)

Data Range: 6/25/2018 – 9/25/2018. Source: Bloomberg. The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate. An investor’s shares, when redeemed, may be worth more or less than their original cost; current performance may be lower or higher than the performance quoted. For standardized performance and the most recent month-end performance, click here.

While this uptick in industrials is seemingly just getting its legs, it’s prudent to get a sense of where this enthusiasm is coming from and whether momentum can carry the sector over the stormy waters of global trade. Below we’ll break down one of the three main industries that make up the industrial sector and determine if it can continue driving the market to new highs before the end of the year, or whether the industrial trade might break down, piece by piece. In this article we’ll take a look at Defense.

It was not until September that industrials started to diverge. It turns out that this split corresponds with a jump in the defense industry, something you can see in the chart for the Direxion Daily Aerospace & Defense Bull 3X Shares ETF (DFEN)

DFEN vs. Dow Jones U.S. Select Aerospace & Defense Index (DJSASDT)

Data Range: 9/1/2018 – 9/25/2018. Source: Bloomberg. The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate. An investor’s shares, when redeemed, may be worth more or less than their original cost; current performance may be lower or higher than the performance quoted. For standardized performance and the most recent month-end performance, click here.

Among the biggest drivers of this jump is United Technologies, which has surged nearly 8 percent (as of 9/24/18) since it reported solid Q2 earnings late in July. UTX is also rapidly nearing its $30 billion acquisition of Rockwell Collins following some divestments in conflicting areas of its business.

Others in the space like Boeing and Lockheed Martin have also climbed about 10 percent in the past month after finalizing some sizable agreements with Uncle Sam. Boeing’s up following the announcement of a $2.9 billion defense contract while Lockheed Martin rose on news on a massive $7.2 billion contract to develop a next generation GPS.

As you can probably tell by now, the best thing the industry has going for it is a government willing to make these multi-billion dollar deals. Prior to the recent late-summer rally, both companies traded down more than 10 percent from their 2018 high. On top of that, others in the industry like Northrop Grumman and General Dynamics traded at or near 52-week lows through much of the third quarter.

It’s clear that the biggest catalyst for this industry is the people’s checkbook. Since the Senate just approved a $17 billion increase to the pentagon’s budget, there’s not much reason to expect these companies to get kicked off the dole anytime soon.

However, depending on whether the less hawkish Democrats manage to flip the legislature this November — the prospect alone could cause some traders to shift some of their exposure — there’s a chance the Trump administration might see greater resistance to further spending if there’s a return of deficit hawks in congress.

If defense spending does get the axe, orders in Boeing’s international aeronautics business stand to buoy that company. However, research from McKinsey & Company shows U.S. defense spending is heavily correlated with the revenue of defense contractors, so stragglers like Northrop or Lockheed could be harder hit without a steady stream of federal contracts and a potentially tighter fiscal outlook.

For now, the lack of overexposure to international markets is a boon for defense stocks. However, if and when U.S. monetary policy really starts to tug on national purse strings, the contractors could start feeling the pinch.

Related Leveraged ETFs

 

 


Each leveraged ETF seeks investment results that are 300% of the return of its benchmark index for a single day. Each Fund should not be expected to provide returns which are three times the return of benchmark’s cumulative return for periods greater than a day. Investing in a Direxion Shares ETF may be more volatile than investing in broadly diversified funds. The use of leverage by a Fund increases the risk to the Fund. The Direxion Shares ETFs are not suitable for all investors and should be utilized only by sophisticated investors who understand leverage risk, consequences of seeking daily leveraged investment results and intend to actively monitor and manage their investment.
 
DUSL Risks – An investment in the Fund involves risk, including the possible loss of principal. The Fund is non-diversified and includes risks associated with the Fund concentrating its investments in a particular industry, sector, or geographic region which can result in increased volatility. The use of derivatives such as futures contracts and swaps are subject to market risks that may cause their price to fluctuate over time. The Fund does not attempt to, and should not be expected to, provide returns which are three times the performance of its underlying index for periods other than a single day. Risks of the Fund include Effects of Compounding and Market Volatility Risk, Leverage Risk, Counterparty Risk, Intra-Day Investment Risk, Daily Index Correlation/Tracking Risk, Other Investment Companies (including ETFs) Risk and risks specific to investment in the securities of the Industrials Sector. Please see the summary and full prospectuses for a more complete description of these and other risks of the Fund.
 
Industrials Select Sector Index (IXITR) –  Provided by S&P Dow Jones Indices and includes domestic companies from the industrials sector which includes the following industries: aerospace and defense: industry conglomerates; and machinery. One cannot directly invest in an index.
 
DFEN Risks – An investment in the Fund involves risk, including the possible loss of principal. The Fund is non-diversified and includes risks associated with the Fund concentrating its investments in a particular industry, sector, or geographic region which can result in increased volatility. The use of derivatives such as futures contracts and swaps are subject to market risks that may cause their price to fluctuate over time. The Fund does not attempt to, and should not be expected to, provide returns which are three times the performance of its underlying index for periods other than a single day. Risks of the Fund include Effects of Compounding and Market Volatility Risk, Leverage Risk, Counterparty Risk, Intra-Day Investment Risk, Daily Index Correlation/Tracking Risk, Other Investment Companies (including ETFs) Risk and risks specific to investment in the securities of the Aerospace and Defense Industry and the Industrials Sector. Please see the summary and full prospectuses for a more complete description of these and other risks of the Fund.
 
Dow Jones U.S. Select Aerospace & Defense Index (DJSASDT) – Provided by Dow Jones U.S. Index (the “Index Provider”). The Index attempts to measure the performance of the aerospace and defense industry of the U.S. equity market. The Index Provider selects the stocks comprising the Index from the aerospace and defense sector on the basis of the float-adjusted, market capitalization-weight of each constituent. Aerospace companies include manufacturers, assemblers and distributors of aircraft and aircraft parts. Defense companies include producers of components and equipment for the defense industry, such as military aircraft, radar equipment and weapons. One cannot directly invest in an index.