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Are Defense Sector ETFs A Post-Sequester Bargain?

NEW YORK ( ETF Expert) --The closest thing to bipartisanship in the presidency of Barrack Obama may have come a few weeks ago. Eight prominent Senators -- four Democrats and four Republicans -- have been crafting an immigration reform bill that many believe could eventually become law.

However, finding common ground on economic issues has eluded members of Congress for years. The Senate hasn't passed a budget since 2009. With the exception of an eleventh-hour tax rate hike in the "fiscal cliff" conversations, nearly every major financial decision has been an exercise in delay.

Most notably, in early July 2011, Republicans did not want to agree to raising the country's debt limits without corresponding spending cuts. Democrats did not want to agree to spending cuts to social programs, and strongly preferred tax hikes to lower the ever-increasing public debt.

Due in large part to the partisan wrangling, U.S. stocks declined roughly 20% from their intra-year peaks. It wasn't until August 2011 that both sides agreed to an enforcement mechanism (a.k.a. "the sequester") for an eventual deficit reduction package; that is, come up with a bipartisan bill that will pass or accept across-the-board cuts, half of which will be in the arena of "non-essential" defense spending.

Deadline after deadline passed without consequence. Even the Jan. 2, 2013, date for sequestration had been pushed back to March 1. As far as anyone can tell, there has been no bipartisan bill for cutting $1.2 trillion from the deficit over time.

It follows that scores of market-watchers, analysts and economists expect Democrats and Republicans to let the automatic cuts go into effect. Specifically, the government will cut $600 billion from defense and another $600 billion from other government "faves." (Note: Major social programs like Social Security are not part of the equation.)

The curious questions that naturally result include:

(1) Will leaders come up with another eleventh-hour postponement?

(2) Will the stock market tumble if they don't?

(3) Are defense sector stocks particularly vulnerable?

I am neither a political insider nor a clairvoyant. Yet, I do have opinions on likely outcomes.

On the first question, you should not expect another eleventh-hour deal. Leaders from both parties will let the automatic spending cuts go into effect.

U.S. politicians are not feeling enough pressure from citizens nor peers to come to an arrangement. Moreover, Republicans genuinely believe that out-of-control spending is the issue requiring action, whereas Democrats genuinely believe that more revenue via taxation is a better prescription and that government spending is necessary to keep the economy on track.

Disparate philosophies and a lack of urgency when stocks are near all-time highs suggest that sequestration's automatic cuts will occur.

How will the stock market react? Up until now, stocks have acted with indifference to harmful realities and real possibilities with respect to economic growth. In some instances, the markets even celebrate bad news since it often implies that the Federal Reserve will need to stay its course of intervening in the bond markets to keep rates artificially low.

Nevertheless, I expect profit taking... and I expect it to be sharp. A correction of 5% may occur in a matter of a few weeks. (Note: Stock markets frequently give back half of a recent uptrend, and that is what I anticipate.)

The final question, how might defense corporations fare when sequestration kicks in and stocks pull back? PowerShares Aerospace and Defense Portfoflio (PPA) and iShares DJ Aerospace and Defense (ITA) are not immune to selloffs. Indeed, they will fall as much as the market, and probably a bit more.

Both PPA and ITA fell more than the S&P 500 in the week that followed the general election, as investors worried about a fiscal cliff calamity. The exchange-traded trackers rallied back nicely with the rest of the market as progress seemed to occur.
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