The Dow's Secret Weapon: Defense Old-Timers

The 30 arthritic, old prizefighters of the Dow Jones Industrial Average -- once widely derided as irrelevant, if not actually dead -- have bounded off the ropes to flatten their brash young rivals so far in 2002, rising 3% as a group through March 1, in contrast to the 8% decline of the Nasdaq Composite and the 1% decline of the S&P 500.

Powered by strength in the military-industrial complex, as you'll see in a moment, the knockout blow came in a February that was remarkable for its 11-percentage-point divergence between the returns of the Dow and the Nasdaq. That was the fourth-widest one-month differential, +2% for the Dow vs. -9% for the Nasdaq, since 1982. The three greater divergences all came in the past two years, and each led to one more month of sharp differential in the same direction, and then a month of reversal. (See the table below.)

In large part as a result of its bravura February, the cumulative performance of the Dow 30 has for the first time in a decade pushed into the lead over the Nasdaq and S&P 500 over every significant long-term period, starting with the day before last year's terror attack:

The Old Warhorse Wins The Dow outpaces the Nasdaq and S&P in the long run

Since Sept. 10, the Dow is up 8%, while the S&P 500 is up 4% and the Nasdaq is up 6%.

In the past 12 months, the Dow wins, -1% vs. -9% for the S&P and -16% for the Nasdaq.

In the past 24 months, the Dow wins, +3% vs. -16% for the S&P and -61% for the Nasdaq.

In the past 36 months, the Dow wins, +11% vs. -8% for the S&P and -21% for the Nasdaq.

In the past 60 months, the Dow wins, +51% vs. +43% for the S&P and +38% for the Nasdaq.

In the past 120 months, the Dow wins, +217% vs. +174% for the S&P and 185% for the Nasdaq.

In the past 240 months, the Dow wins, +1,152% to 899% for the S&P and 637% for the Nasdaq.

The lesson here is profound for investors of all stripes. The Dow Jones Industrials are 30 stocks chosen by Wall Street Journal editors for their representation of the U.S. economy. The lineup is changed at a glacial pace compared with the S&P 500 and the Nasdaq 100, and thus it represents the virtues of both long-term investing and value investing.

The last changes to the Dow came in November 1999, when Intel (INTC Quote - Cramer on INTC - Stock Picks), Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks), Home Depot (HD Quote - Cramer on HD - Stock Picks) and SBC Communications (SBC Quote - Cramer on SBC - Stock Picks) were added. In contrast, Standard & Poor's changes horses at least once a month, and the Nasdaq 100 -- which accounts for almost all of the movement of the Nasdaq Composite -- changes substantially every year.

While both the S&P 500 and Nasdaq 100 have seen several of their components sink below $1 in the past two years -- Enron (ENRNQ Quote - Cramer on ENRNQ - Stock Picks), Kmart (KM Quote - Cramer on KM - Stock Picks), BroadVision (BVSN Quote - Cramer on BVSN - Stock Picks) and Exodus Communications (EXDSQ Quote - Cramer on EXDSQ - Stock Picks) come to mind -- the Dow 30 have been a rock of stability, as the worst performers in one year have an uncanny knack for rebounding the next. In 2000, for instance, Microsoft was the worst Dow performer; in 2001 it was the best. In 2001, Boeing (BA Quote - Cramer on BA - Stock Picks) was the worst performer. So far in 2002, it's one of the best.

Secret Weapon: Defense

Bears have warned that the market's recent surge has reflected too much optimism about the potential for continued consumer spending and a revival in business spending this year. But both of those arguments ignore the plain fact that the Dow's secret store of energy this year has come from shares of companies tied to military spending.

Indeed, you could say that defense stocks have turned out to be the cavalry of the 2002 stock market, leading the charge in a way not witnessed since the early '80s. United Technologies (UTX Quote - Cramer on UTX - Stock Picks), Boeing and Honeywell (HON Quote - Cramer on HON - Stock Picks) are all up 60% to 80% since the terror attacks in September, adding ka-pow to the Dow.

Those three stocks could be done for now, as their exposure to commercial aviation may hamper progress. But many of their peers face the real prospect of double-digit earnings growth due to increases in Defense Department purchasing over the next five years. Bombs and missiles and guidance systems are the consumer nondurables of Planet Pentagon, and as both the war on terrorism and training for future wars progress, inventories are rising from extremely depleted levels and will need constant replenishment. Perhaps one day we will be bemoaning the "bullet bubble," but for now it's full speed ahead on the stockpiling of these companies' products.

Paul H. Nisbet, a veteran aerospace analyst at JSA Research in Newport, R.I., notes additionally that defense contractors are in some circles considered a safe haven from the accounting issues afflicting the rest of Wall Street. He's got two reasons. First, earnings prospects are consistent enough not to compel managers to fudge to make their numbers. Second, all of their deals with the Pentagon are scrutinized by civil servants at the federal Defense Contract Audit Agency, which is believed to be much harsher than your local Arthur Andersen office.

Eight Stocks With Promise

Nisbet, who has studied these stocks for more than 30 years, says he likes Boeing and Honeywell least among the Dow Jones Industrials' defense stocks. But he likes plenty of non-Dow 30 defense stocks quite a bit, including large-caps Northrop Grumman (NOC Quote - Cramer on NOC - Stock Picks), General Dynamics (GD Quote - Cramer on GD - Stock Picks) and Alliant Techsystems (ATK Quote - Cramer on ATK - Stock Picks), Lockheed Martin (LMT Quote - Cramer on LMT - Stock Picks) and Raytheon (RTN Quote - Cramer on RTN - Stock Picks) and small-caps Curtiss-Wright (CW Quote - Cramer on CW - Stock Picks), EDO Corp. (EDO Quote - Cramer on EDO - Stock Picks) and DRS Technologies (DRS Quote - Cramer on DRS - Stock Picks).

The researcher, who sells his thoughts on the industry for as much as $3,500 per 30-page report, says he foresees a military buildup on the scale of the Reagan era. At that time, he said, the stocks ran for five years before peaking. In this case, he starts that clock in 2000, when investors first began to believe George W. Bush could win the election and began to bid these names up. "We have at least three years left," he said. "Maybe four."

Four more parallels with the Reagan era: Both periods followed roughly eight years of armed-forces deterioration in which Pentagon spending sank to 3% of gross domestic product from highs around 8%; both presidents ran their campaigns on rebuilding the military; both presidents garnered public support via a single, powerful negative event (for Reagan, it was the Iran hostage crisis); and both periods followed recessions that made downturn-proof defense stocks look unusually attractive.

Nisbet believes the greatest growth will come in space weapons such as the new antiballistic missile system, which could be ready to test its capacity to knock down an intercontinental ballistic missile by 2004. That's the main reason Northrop has launched an expensive bid for TRW (TRW Quote - Cramer on TRW - Stock Picks), the premier contractor in military spacecraft, satellite communications and high-energy lasers. And it opens the door to a surge in the many small-cap manufacturers of satellite, propulsion and space-communication sub-systems, such as DRS and Orbital Sciences (ORB Quote - Cramer on ORB - Stock Picks).

Here's a quick strafing run on Nisbet's view of key stocks in the group:

Lockheed Martin. Much-improved management and well positioned for both military and space spending, with brilliant recent contract wins on all fronts. Expects 60% annualized earnings growth over next five years, in large part because of Joint Strike Fighter and F22 projects, but also due to its rebound from very low levels. Yet it is also the most expensive, trading at 22.6 times forward four-quarter earnings.

Boeing. Strong management from acquired companies McDonnell-Douglass and Rockwell. Well positioned for future space contracts but more trouble ahead on the commercial jet side of the house. Earnings expected to be flat to down for the next two years, then better after 2003. Expects 5% annualized earnings growth over next five years. "Could do better, but buying now is too risky."

Honeywell. Management strong and improving with addition of new chief executive. Stock still a bit depressed following the failure of its merger agreement with General Electric (GE Quote - Cramer on GE - Stock Picks) and exposure to commercial aviation. Expects 12% annual earnings growth. "They will do well, but we have them on our sell list due to risk on the commercial side."

Northrop Grumman. Management is least liked on Wall Street because the chairman is aggressive and has pushed the company's debt several times to the brink of junk status. Would nevertheless use recent decline in wake of the TRW merger bid to pick up shares, as 17% earnings growth is expected over the next five years, and valuation is depressed relative to peers at a forward price-to-earnings ratio of 16.3. Chairman also expected to follow through on promise to reduce the firm's debt-to-capital ratio sharply by end of year even if TRW is acquired.

Raytheon. Premier manufacturer of air-to-air and air-to-ground tactical missiles, as well as radar, warheads and surveillance equipment for space defense. Management has improved after addition of chief executive from Allied-Signal. Earnings growth expected at around 17% annualized over next five years. Valuation reasonable at 17 times forward earnings. "Strong demand for their consumables -- smart weapons such as Paveway and HARM."

Bombs away.