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Best, Worst of 2013: Northrop Grumman vs Caterpillar

NEW YORK (TheStreet) --Typically when the stock market goes up a lot the industrial sector goes up more. That has been true in 2013. The SPDR S&P 500  (SPY) was up 29% through last Friday compared a 37% lift for the Industrial Select Sector SPDR (XLI).

This is normal market behavior and works in reverse when the market goes down a lot. In 2008, SPY was down 38% and XLI went down 40%. This is a cornerstone of top-down investing. Some sectors do better during rallies and should be overweighted in a portfolio.

That has helped Northrop Grumman (NOC) but not Caterpillar (CAT), as you will see.

The reason the industrial sector does better during upswings is that a healthy economy and healthy stock market means more heavy, expensive things made out of metal get sold.

An excellent example of this effect is Northrop Grumman, one of the few large-cap, (almost) pure play defense contractors. Its 66% gain year to date puts it ahead of General Dynamics  (GD)Lockheed Martin (LMT) and the iShares US Aerospace & Defense ETF (ITA), which have all gained a market beating 34% to 56% respectively so far this year.

The argument for owning the defense industry is simple: These companies produce equipment the military uses to protect the country. The industry is clearly vulnerable to debt ceilings, sequestration and other government dysfunction, but no politician wants to face their electorate as being the guy who did not do everything possible to protect the country and the troops.

A growth catalyst for the defense industry, aside from the world becoming increasingly more complicated, is the extent to which defense equipment has become increasingly reliant on technological innovation. Again, if superior technology will save American lives then the government will spend the money and, of course, the defense contractors will continue to innovate because it is in their interests to do so.

As there is always a need to maintain the country's defense there is always an argument to own a defense contractor directly or through an ETF like ITA. A repeat of 2013as stellar gains for the group is unrealistic unless the broad market somehow puts in a repeat performance.

All of the defense stocks correlate close together and the recent history of the group, in the nine years my firm has owned NOC for clients, is that the stocks tend to take turns providing performance leadership with no discernable pattern which makes the argument for going with ITA for investors most concerned with price appreciation.

Dividend investors would be better off considering the larger individual stocks for their superior yield. NOC yields 2.1% and has increased its dividend ten years running. GD yields 2.4% and LMT yields 3.7% compared to just 1.6% for ITA.

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