The Myth Of Defense Spending Cycles
Human beings search for patterns. It's one of the traits that makes us different from squirrels. But sometimes we insist on finding patterns that are not really there. A case in point is the notion that defense spending follows a mechanistic pattern of boom and bust cycles. This idea is explicitly or implicitly present in much of the analysis generated by Wall Street analysts about the defense sector. For example, on September 8 Merrill Lynch Bank of America put out a research note entitled "Defense budget surrender, a headwind for contractors," in which the authors observed, "Over the last 30 years each downward or upward trend [in U.S. defense spending] tended to last 10 years." The note suggested that since the defense increases of the Bush era appear to have ended, the sector is now headed into a decade-long downturn. That interpretation is unprovable and probably wrong. If China's military sinks a U.S. aircraft carrier tomorrow, Pentagon spending will resume its upward march overnight.
It isn't hard to understand the appeal of cycles. Our lives follow the daily and yearly rhythms dictated by the time it takes the planet to complete one revolution and circle the sun. Our bodies progress through stages from birth to death that are readily identifiable and immutable. So it is second nature for human beings to formulate metaphors such as the business cycle and the product life cycle that help them to interpret economic developments. My favorite theory of economic cycles is the Kondratiev wave theory, dreamed up by a Soviet economist during Stalin's reign to explain why capitalist economies would periodically collapse due to structural imbalances. Some westerners bought into Kondratiev's theory as an explanation for stock-market crashes, because it seemed to explain long-term cycles underpinning the behavior of equity markets. But like the navigation tools of ancient mariners that were based on a geocentric universe, the seeming success of such theories in predicting certain outcomes isn't necessarily grounded in an accurate understanding of the world.
So it is with theories of defense spending cycles. Analysts who subscribe to the idea that there is an intrinsic periodicity to defense spending typically focus on the pattern of postwar military outlays, seeing both regularity and limits in the way the outlays varied. Within that constrained timeframe, there really does seem to be a cycle: defense spending peaked during the Korean War, then during the Vietnam War, then during the Reagan era -- seemingly at regular intervals of about 20 years. Furthermore, when the effects of inflation are removed, military expenditures seemed to stay in a "trading range" of buying power during the entire period. So that suggests there really may be a predictable cycle underpinning the defense market, right?
Wrong. If you broaden the time aperture, both the periodicity and the trading range evaporate. The world wars may have been about 20 years apart just like Korea and Vietnam were, but the Korean War followed the Second World War by only six years, and the United States had not seen a major military buildup prior to its entry in World War One for over half a century. There may have been a temporary pattern of regularity during the Cold War because the Soviet threat was unusually protracted and predictable, but that danger has now been replaced by threats that everyone agrees are unpredictable. And, oh, by the way, George W. Bush's global war on terror lifted defense outlays above the spending range of the previous 50 years.
The bottom line for investors is that there is no theory of spending cycles that can reliably guide them to profits in the defense sector. Military outlays rise and fall largely in response to non-economic factors -- mainly foreign threats and domestic politics -- that cannot be modeled in advance and often come as a colossal surprise to the experts. If you are pulling your money out of defense equities in the expectation of a ten-year downturn, you are probably going to be disappointed the same way people were who took that advice a decade ago (I was one of those "experts" who predicted no land wars in Asia during the first decade of the new millennium). It's fine that analysts search for patterns -- that's what we pay them to do -- but if you think that threats and political realignments unfold according to some mechanistic timetable, then you need to take a history course at your local community college.