The world is no stranger to conflicts and geopolitical tensions. Recent events, such as the surge in violence in the Middle East, the Russian invasion of Ukraine, and ongoing nuclear threats, have raised questions about how war affects the US stock market. Let’s explore the relationship between war and the stock market, shedding light on historical trends, the impact on defense stocks, and the broader economic implications.

The Economic Impact of War

Historically, international conflicts and military engagements have had varying effects on the US stock market. While war and defense spending can contribute significantly to the country’s GDP, they often have limited and short-lived impacts on stock markets or domestic economic growth.

In recent years, the US has spent an estimated $8 trillion on post-9/11 wars, representing a substantial portion of the GDP. Despite this substantial spending, conflicts related to the Middle East and Iran have often been largely ignored by stock markets.

Conflict in Israel and Stock Market Response

The recent surge in defense stocks following the conflict between Israel and Palestinian militants illustrates the complex relationship between war and the stock market. While the iShares U.S. Aerospace & Defense ETF experienced a 6% increase, led by companies like Lockheed Martin and Northrop Grumman, it is essential to note that such market reactions are typically short-lived. The S&P 500 initially dipped but eventually recovered as the conflict unfolded.

Graph 1: S&P 500 Index Price From the Simchat Torah Hamas Massacre of Israeli Civilians to Several Days After

One reason for the limited and short-term market impact is that conflicts in the Middle East have become a recurring occurrence, and the market has learned to adapt to these periodic escalations. However, a broader regional war could have more severe consequences, particularly on oil and commodity prices, which would likely affect the overall market.

The Impact on Defense Stocks

Conflict often leads to a surge in defense stock prices. The Russian invasion of Ukraine initially boosted the defense sector, with companies in this industry seeing their stocks rise. However, it’s important to recognize that defense projects typically follow multi-year timetables. This means that any short-term sales boost from a conflict is unlikely to have a significant and sustained impact.

Key Companies in the Defense Sector

Several prominent companies in the defense sector play a crucial role in the US economy. These companies focus on various aspects of defense, including aviation, space, missiles, nuclear efforts, shipbuilding, and defense IT. Here are a few key players:

• Lockheed Martin (NYSE: LMT) +9.71%(5D): The world’s largest defense company and the lead contractor for the F-35 Joint Strike Fighter.

• Boeing (NYSE: BA) +2.96%(5D): Known for commercial airplanes, Boeing also has a significant defense business involved in aircraft, space, and helicopters.

• Northrop Grumman (NYSE: NOC) +13.92%(5D): Responsible for stealth bombers and a large space portfolio, with ties to the nuclear triad.

• General Dynamics (NYSE: GD) +9.93%(5D) : A major military shipbuilder with a portfolio of tanks, land vehicles, and defense-focused IT and services.

• Raytheon Technologies (NYSE: RTX) +6.15%(5D): Specializing in defense electronics, missiles, and aerospace components.

• Leidos Holdings (NYSE: LDOS) +5.07%(5D): The largest government IT company, expanding into hardware and classified research capabilities.

Investing in Defense Companies

Investors considering defense stocks should pay attention to several key factors:

• Government Funding: Keep an eye on the annual budget requests sent to Congress by the Pentagon. The budgeting process and allocation choices can provide insight into which defense programs are a priority.

• Free Cash Flow: Analyze the free cash flow of defense contractors, as it can vary based on the stage of their projects. Early-stage production contracts may temporarily impact cash flow.

• Corporate Backlogs: Corporate backlogs represent future awarded contracts not yet executed. Understanding how much of the backlog is funded and subject to congressional approval is crucial.

• Book-to-Bill Ratio: This metric compares orders received with the amount billed, indicating a company’s growth potential. A ratio of at least 1.0 suggests that future orders are keeping pace with current shipments.

The Bottle line

The relationship between war and the US stock market is complex, with historical data suggesting that stock markets tend to recover quickly following conflicts. The defense sector often performs well during times of conflict, but the long-term effects on defense stocks depend on factors like government funding and research priorities. While conflicts may lead to short-term boosts in defense stocks, their sustained impact on the market is contingent on various economic and geopolitical factors. Investors should carefully consider these dynamics when navigating the defense sector.