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Take Careful Aim at Defense Stocks

Editor's Note: Jon D. Markman writes a weekly column for CNBC on MSN Money that is republished here on

Misguided missiles seem to be flying around the world at record rates these days. Predictably, shares of the largest defense contractors are hitting all-time highs.

Investors have always turned to big Pentagon vendors for safe haven in times of fear and mayhem. Yet I can't help wondering if the smell of burning cordite won't be coming just from these companies' products but also from their falling stocks. They're rather expensive at a time when military spending is slowing.

Shares of most small defense contractors already have been pummeled, with many trading at multiyear lows. Either the smaller companies will soon turn around or the larger outfits will stall. The latter is more likely, as military spending plateaus from sheer exhaustion in the U.S. after a tremendous post-9/11 rise. The defense budget may face trimming if Democrats win a majority in Congress this fall.

So what's the right strategy to put your portfolio on a war footing? Go long selected defense contractors now, but trail a sell-stop to capture profits in case peace breaks out. Meanwhile, avoid contractors with a lot of exposure to commercial aviation.

Darlings in Volatile Times

Defense stocks are popular with investors during times of market volatility because their performance tends not to be correlated with the S&P 500. They tend to be linked to national threats more than to macroeconomic factors.

Since the Pentagon budget amounts to only 3% of U.S. gross domestic product, defense spending itself has limited impact on the rest of the market, according to a recent analysis by brokerage Sanford Bernstein. The upshot: The Pentagon could spend a ton on weapons systems, and it wouldn't have much effect on gross domestic product gains. But it would have a huge effect on contractors.

Lockheed Martin (LMT) and Northrop Grumman (NOC) are the best defense plays because, according to Bernstein's analysis, they have the lowest correlation with the broader economy. If you can take just one, I'd give a nod to Lockheed because of its exceptional operational results and focus.

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