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As we mentioned in a recent note on Northrop Grumman (NYSE:NOC), we believe US space and defense spending is set to rise. The world has changed course in recent years. From the end of World War II to the middle of the financial crisis, the world economy was characterized by increasing liberalization (reduction in tariffs and non-tariff barriers to trade; increasing ease of flows of capital, services, goods and people) - a side benefit of which has been that there are fewer countries liable to fight one another and therefore a relatively peaceful seventy years. (Liberal democracies rarely go to war with one another).

The postwar economic boom and long period of peace in the West are largely behind the stupendous progress achieved by the Boomer generation. More money and less mortality. Hence the "OK Boomer" ire of the young who are facing less money for sure and quite possibly more mortality.

We're now in a more fractious period of history. (This is going to bring its own challenges for the Boomers - we'll write about that in due course). We think a near-term consequence of the rising friction between East and West, the splinters among NATO members, and the relatively unnoticed global acceptance of a new warfighting domain - space - is that defense spending is likely to rise globally. The US in particular will, we believe, see a gradual rise in the coming years, as it normalizes back to at least an average level of post-war spending as a % of GDP (click the link to our NOC note above to see a useful chart on this).

One thing that Boomers have proven very good at is growing asset prices. No more so than in the US equities market. Since WWII, US equities have been the single best asset class as a balance of risk and reward in many folks' eyes (including those of Warren Buffett). And shrugging off a fit of hiccups in 2007-2009, US equities have continued apace. GDP growth has been sluggish in the US since the crisis, but thanks to the Fed - more Boomers in charge - the S&P 500 has positively powered away up and to the right. Check our chart on that topic here.

Now, even if the world is becoming more atavistic, whilst the Boomers hold the reins, one consolation is that defense stocks ought to benefit.

So in the modern idiom, if you have a view on a sector, you should just pick a sensible, low-fee ETF, buy some, and go play golf, right?

Wrong. At least not in defense, not right now. Because there's one huge company in the aerospace & defense sector with some huge problems - Boeing (BA). We expand on the topic in this note. We don't know if BA is going to right itself any time soon, but generally speaking when corporations go through this much pain, it takes a long time for them to regain their footing. There are plenty of BA bulls here on SA and elsewhere who will tell you that it will all be over by next year - and maybe they are right. But that's a big call. Our own view is that there remains trouble ahead at Boeing, because things will continue to crawl out from under the rocks that regulators continue to study. We would be surprised if the current CEO were in situ this time next year; and if there's a new CEO you can bet that s/he will want to clean house with a kitchen-sink full of writedowns, writeoffs, disposals, etc., to level set them for personal success going forward. So we continue to worry about BA stock.

But if you're not careful, that passive ETF you buy into is buying you a whole heap of BA risk.

The most popular ETF in the aerospace & defense sector is (BATS:ITA). It's an iShares product and so it's easy to buy and carries a reassuringly familiar brand.

But this year it has lagged the pack of defense stocks. Here's a brief illustration of that - see ITA below charted against a basket of defense single-name stocks, including Aerojet Rocketdyne (AJRD), BA, L3Harris Technologies (LHX), Lockheed Martin (LMT) and Northrop Grumman.

ITA returned 23% this year so far - none too shabby by historical standards. But it's 7% shy of the worst performing single name in our stocks below.

Source: YCharts.com

Why? Because it has a heavy weighting to BA - 21% at the time of writing. And BA returned just less than 2% this year. Whereas sector winners like Northrop Grumman are up above 30% for the year.

Here's the major components of ITA.

Source: Seeking Alpha

To illustrate the damage that BA has done to the ITA portfolio, take a look at (NYSEARCA:XAR), an equivalent ETF product from S&P. XAR is up 32% this year, as good as any underlying stock in the group. And here's why - look at its holdings:

Source: Seeking Alpha

There are major BA suppliers in there for sure - namely TransDigm Group (TDG) and Spirit AeroSystems (SPR). And we think those companies are going to suffer from BA's problems in 2020. But so far they weren't hit too badly. And so XAR has really delivered this year.

If you think BA will work out just fine, both ITA and XAR can be good products for you. But if, like us, you worry about BA and you worry about its supply chain, then you probably want to think about starting to invest in the underlying stocks.

As we have written elsewhere, we cover most of the top stocks in the sector and there's plenty of our material on those stocks available here on SA.

Stocks in the sector we like right now include NOC (our rating - Buy - Long Term Hold) and AJRD (our rating - Buy - Long Term Hold). We think LHX has a great business but we worry the stock is extended. We think Raytheon (RTN) and United Technologies (UTX) have some rationalization to do, but we could imagine going back to Buy next year once the merger is completed. And we want to avoid BA altogether right now.

To your investing success!

Cestrian Capital Research, Inc. - 16 December 2019.

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Disclosure: I am/we are long AJRD, NOC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: We are long AJRD and NOC on a personal account basis.

Originally posted here:

We Think Defense Spending Is Going To Boom - But iShares U.S. Aerospace & Defense ETF May Miss Out - Seeking Alpha