Defense stocks: The so-simple-it’s-obvious trade that may be just getting started
First-level thinking vs. second-level thinking
Howard Marks, the co-founder of Oaktree Capital Management and author of “The Most Important Thing,” emphasizes the importance of what he calls “second-level thinking” when making trades. Rather than explicitly defining the term, Marks used the following examples in his 2015 note, “It’s Not Easy,” to show the difference between first-level thinking and second-level thinking:
- ‘First-level thinking says, “It’s a good company; let’s buy the stock.”Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not.So the stock’s overrated and overpriced; let’s sell.”
- First-level thinking says, “The outlook calls for low growth and rising inflation.Let’s dump our stocks.”Second-level thinking says, “The outlook stinks, but everyone else is selling in panic.Buy!”
- First-level thinking says, “I think the company’s earnings will fall; sell.”Second-level thinking says, “I think the company’s earnings will fall far less than people expect, and the pleasant surprise will lift the stock; buy.”’
In Marks’ words, “The bottom line is that first-level thinkers see what’s on the surface, react to it simplistically, and buy or sell on the basis of their reactions.”
While this framework obviously works for Mr. Marks – he’s a multi-billionaire investor after all! – it’s also true that simplistic first-level thinking can absolutely trounce more sophisticated second-level thinking in certain market environments.
We only have to go back to the emergence of the COVID pandemic in 2020 to see so-simple-it’s-obvious trades like Zoom Video (ZM) surging 700% in the first ten months of the year, primarily on the back of a thesis so straightforward that a preschooler would understand it: “People can’t see each other in person any more, so they will need to do more video chatting!”.
(Of course, ZM has since given back about 80% of its 2020 gains as countries have gotten a better grasp on the pandemic, so there’s certainly an argument that at least some second-level thinking could have protected traders from a huge loss!)
Why defense stocks may be entering a secular bull market
This long introduction brings us to the so-simple-it’s-obvious, first-level thinking trade that may be just getting started: Defense stocks. Russia’s ongoing invasion of Ukraine has viscerally reminded countries across the globe of the importance of spending on defense and military equipment. To take one example, NATO collectively spent $1.1T on defense in 2021, with large countries like Canada, Germany, Italy, and Spain spending well below the mutually-agreed 2% minimal threshold:
Source: NATO, BofA Global Research
Notably, the US was spending as much as 7% of its GDP on defense during the Cold War, and though we all hope to avoid such a scenario in the future, it shows that there is historical scope for a dramatic increase for all these figures. At a minimum, it seems clear that NATO countries will almost certainly spend substantially more on defense in 2022 than they did in 2021, providing an obvious, but undoubtedly potent, tailwind for major defense companies, one that is likely to persist for years to come.
Defense stocks to watch in 2022 and beyond
Defense companies are heavily dependent on economies of scale and relationships with policymakers, so it’s logical to expect that the largest companies will be among the biggest beneficiaries of increased military spending. The biggest players in the defense industry by revenues are Lockheed Martin (LMT), Raytheon Technologies (RTX), Boeing (BA) and Northrop Grumman (NOC).
As the charts below show, three of these four names have broken out to fresh record highs in the last week, with Boeing’s struggling airplane manufacturing business making it a notable laggard:
Source: TradingView, StoneX
With defense spending seemingly poised to surge in the coming quarters, regardless of when and how the Russia-Ukraine conflict comes to an end, traders will likely be looking to buy any dips in shares of LMT, RTX, and NOC in the coming months as long as they remain above their previous highs. For readers who would prefer to play the theme more generally without taking on idiosyncratic equity risk, the iShares US Aerospace and Defense ETF (ITA) holds more than 30 stocks in the sector, with nearly a 50% weighting in the above four names.
As Howard Marks has shown, “beating the market” with contrarian second-level thinking can be immensely profitable, but sometimes the simplest first-level thinking trades can be just as successful if you don’t overthink it!
How to trade with FOREX.com
Follow these easy steps to start trading with FOREX.com today:
- Open a Forex.com account, or log-in if you’re already a customer.
- Search for the market you want to trade in our award-winning platform.
- Choose your position and size, and your stop and limit levels.
- Place the trade.
The information on this web site is not targeted at the general public of any particular country. It is not intended for distribution to residents in any country where such distribution or use would contravene any local law or regulatory requirement. The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. Any references to historical price movements or levels is informational based on our analysis and we do not represent or warranty that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness, nor does author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.
Futures, Options on Futures, Foreign Exchange and other leveraged products involves significant risk of loss and is not suitable for all investors. Losses can exceed your deposits. Increasing leverage increases risk. Spot Gold and Silver contracts are not subject to regulation under the U.S. Commodity Exchange Act. Contracts for Difference (CFDs) are not available for US residents. Before deciding to trade forex, commodity futures, or digital assets, you should carefully consider your financial objectives, level of experience and risk appetite. Any opinions, news, research, analyses, prices or other information contained herein is intended as general information about the subject matter covered and is provided with the understanding that we do not provide any investment, legal, or tax advice. You should consult with appropriate counsel or other advisors on all investment, legal, or tax matters. References to FOREX.com or GAIN Capital refer to StoneX Group Inc. and its subsidiaries. Please read Characteristics and Risks of Standardized Options.
Please note that foreign exchange and other leveraged trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved, seeking independent advice if necessary.
The products and services available to you at FOREX.com will depend on your location and on which of its regulated entities holds your account.
FOREX.com is a trading name of GAIN Global Markets Inc. which is authorized and regulated by the Cayman Islands Monetary Authority under the Securities Investment Business Law of the Cayman Islands (as revised) with License number 25033.
FOREX.com may, from time to time, offer payment processing services with respect to card deposits through StoneX Financial Ltd, Moor House First Floor, 120 London Wall, London, EC2Y 5ET.
GAIN Global Markets Inc. has its principal place of business at 30 Independence Blvd, Suite 300 (3rd floor), Warren, NJ 07059, USA., and is a wholly-owned subsidiary of StoneX Group Inc.
© FOREX.COM 2024