I must say as someone who has followed Washington very closely as an attorney and political activist I’ve never seen such a bad yet misunderstood piece of legislation affect the market as the debt ceiling bill. Apart from the nonexistent cuts that the bill is going to appoint a bipartisan commission to address (like the Bowles-Simpson commission that almost got its recommendations half way to first base) the fact that this commission is supposed to recommend possible spending cuts or a raise in taxes - or the elimination of deductions – in an election year should not lead us to have much confidence in what, if any, large actions will be recommended over the twelve month period.
Depending on the day, this bill has been portrayed as a job killing revenue cutter by many on the left, and the bill that changed the culture of Washington by the right. While the long-term importance of the bill is up for debate the price action in the market has been decisive and negative. Without question, the one sector that has been most heavily battered by the debt debate punctuated with the brutal near-300 point decline Monday after the Senate approved the final version of the bill, is the defense sector.
Even companies that had good earning reports like Lockheed Martin (LMT) and companies that have less exposure to larger contracts that theoretically would be likely to be the first to be cut like Northrop Grumman (NOC) have been sold off between 15%-20% on average. What is interesting about this sell-off, which seems to be institutional shorting as both stocks have very high short interests with Northrop Grumman having a nearly 10% short interest, is that it's obviously not predicated on economic weakness. These companies had strong earning reports even in 2007, a year when the government took in far less revenue than it will this year, and this shows that these companies' earnings capability are not really tied to the economic cycles. These companies have lost 20% of their market cap primarily if not solely because of the belief that the Pentagon budget will be reduced by 10%-20% over the next several years by the “super” commission that is mandated to make sure new spending doesn‘t increase the current debt levels at 14 trillion over the next several years. These stocks have been so heavily battered that Northrop Grumman now trades at 8x next year's average earnings estimate with a book value just over 1 and a price-to-sales ratio of .5.
Now the last time the defense sector sold off hard was after the 2008 election when everyone was convinced Obama would massively cut defense spending across the board and immediately begin to withdraw troops from both Iraq and Afghanistan. Obama instead waited over a year to make any withdrawals in Iraq while massively increasing American troop deployments in Afghanistan and actually increasing the defense budget even with a Democratic congress. Business went on as usual and these stocks rallied nearly 30%-40% over the next two years. Obama has even strongly resisted calls from even the left in his own party to end the War in Afghanistan or make significant cut in long-term Pentagon projects.
These companies have lost a fifth of their market caps solely because we are now to believe that the massive defense cuts of 10%-20% (over several years with cuts of the roughly 600 billion dollar Pentagon budget suppose to be just 25-30 billion this year) are coming to a defense budget of over half a trillion. It's important to look a little closer at the actual substance of the debt ceiling bill (or lack of it). The “super” commission that is mandated to ensure future spending will not increase the debt will have an equal number of Democrats and Republicans on it, each appointed by their respective leaders in the House and Senate, and will recommend some combination of ways to increase revenue and cut spending to ensure that our debt stays around the current 13-14 trillion level.
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