Defense Stocks Gain on Shifting War Perceptions

The stark realization that war could be longer than expected has been disappointing to many investors, but not to those with stakes in the defense sector -- at least for this week.

Shares of defense companies have rallied over the past few days, as fighting in Iraq has intensified and investors have begun to accept that the war could be lengthy and complicated.

Although the war with Iraq is unlikely to prompt a big increase in weapons production, analysts say the sector could benefit, in the short term, from the perception that war will last longer than originally thought and that equipment will need to be replaced. Still, analysts say a protracted war could be damaging to the industry and that in the long term, questions remain about the group's ability to continue growing as budget deficits expand.

"In general, defense companies are not set up to profit from war," said Morningstar analyst Nicolas Owens. "They're set up to develop systems for the armed forces to be prepared for war, so fighting itself does not benefit the companies that much."

Analysts say that while there could be some emergency purchases from the government, they are likely to be very small. "The Pentagon is not in the business of being caught empty-handed; they're in the business of developing readiness over the long term," Owens said.

Investors didn't see it that way this week, sending the Amex Defense index up 2.7% and shares of Raytheon(RTN Quote - Cramer on RTN - Stock Picks), Northrop Grumman (NOC Quote - Cramer on NOC - Stock Picks) and Lockheed Martin (LMT Quote - Cramer on LMT - Stock Picks) up 3.9%, 4.9% and 6% for the week, respectively.

The defense sector is now well off its worst levels of 2003 -- hit on March 12 -- but it remains down sharply for the year. The Amex defense index has fallen 15% so far this year, as investors have rotated money out of the group and have moved into riskier assets amid hopes for an economic recovery.