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Hot Stocks for the Coming Arms Race

As Cold War rhetoric escalates in Russia, U.S. military contractors prepare to get busy.

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

TheStreet.com.

U.S. generals may have had a "don't ask, don't tell" tingle of a different sort when they saw

photos

of a bare-chested Russian President Vladimir Putin snapped on vacation in Siberia.

American military officials have come to believe that the ex-KGB officer's newly aggressive stance, shown even more convincingly in some steps the buff leader has taken of late, is intended to provoke the West into the sort of confrontation that some in both sides' militaries yearn for.

The end of the Cold War in 1989 may have been great for the nerves of the citizens of the U.S. and Russia, after all, but it's been hell on wheels for the warriors. Russian generals have suffered repeated embarrassments in a long-running guerrilla battle with separatist groups on the country's southern fringe, while the Pentagon has been drawn into maddening battles against hit-and-run insurgencies in Iraq and Afghanistan.

Morale in both formerly proud armies is at an all-time low, and patience is wearing thin.

What better tonic for military leaders on both sides -- not to mention, ahem, defense contractors -- than a massive new arms race ginned up and sold to the media?

Neither side really wants bloodshed, but both are salivating at the opportunity to sell the need to prepare to their respective citizens. National-security threats are as useful for political campaigns as they are for weapons-industry investors, and it's no coincidence that both countries have major elections on tap next year.

In a moment, I will tell you about the U.S. defense contractors most likely to benefit investors in the coming arms race of the 2010s, but first let's take a quick look at how we got here.

A Fossil-Fueled Resurgence

President Ronald Reagan is rightly credited for toppling the Soviet Union by forcing its leaders to spend a ridiculous share of their national wealth on weapons. By 1988, a year before the fall of the Berlin Wall, military spending amounted to as much as 16% of the Soviets' gross national product and was rising 5% per year, a crippling pace.

After President Mikhail Gorbachev made his peace with Reagan and launched the dismantlement of the Soviet empire, arms spending plummeted -- falling by some estimates to a 10th of its former level by 1998. By the start of this decade, virtually all major weapons-system procurement inside Russia had ceased; all arms production was sold overseas.

Meanwhile, the U.S. briefly paused in its own arms buildup but quickly picked up the tempo again. Federal budget documents show that the U.S. will spend at least $650 billion on war efforts this year, a level that is something like 40% of the entire world total. By some estimates, we now spend four times the amount that Russia and China will spend on their militaries combined.

Yet there's a sense of dissatisfaction that the dollars spent on jet aircraft and nuclear subs aren't getting us very far with the hide-and-seek enemies we now face, and that is why some of our generals pine for a good old-fashioned conventional conflict that would pit battalions against battalions rather than a rifle squad against a neighborhood warlord.

Up until four or five years ago, there wasn't much that Russian officials could do about the spending disparity and their own disenchantment, and embarrassed Russian army leaders simply wept in their vodka. But in 2003, energy prices began to triple amid a surge in demand from Asia and a decline in Saudi Arabian production.

By the time Putin was elected to his second four-year term in 2004, Russia found its coffers overflowing with dollars and euros, thanks to nature's gift of the world's largest reserves of oil and gas beneath its frozen eastern tundra. A new spending spree was on.

For a while, Russia seemed content to pursue its agenda as an energy superpower rather than in its old role as a nuclear superpower. Rather than squandering its riches solely on weapons systems, this time around its cash has fueled a broad-based manufacturing and service economy growing at up to 7% per year that supports millions of urban migrants from the mountains of the Caucasus to the steppes of Central Asia.

Film, music, apparel, food, wireless communications, consumer electronics and retail have flourished in the newly decentralized economy, and opinion polls show that the swelling Russian middle class loves the country's muscular, tough-talking boss.

With most of his people's material needs now being met, it now looks as though Putin wishes to reassert Mother Russia's old swagger on the world stage. While he has the ability to throw Western Europe quite literally back into the dark ages by cutting its access to natural gas, he cannot give up the old czarist ambition to obtain military hegemony on the continent. So back to an arms race we shall go.

Arming Up

Stripped to the waist like an ancient warrior king in the photos published last week, Putin apparently wished to show that unlike the dissolute, draft-dodging elite in Western capitals, he is a fit product of

Spetsnaz

training who's ready to lead his nation into the first really big battles of the 21st century.

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In February, he told a security conference in Munich that he objected to the Bush administration's attempt to create a "unipolar" world governed by "one sovereign" from "one single center of decision-making." Then earlier this month, Putin horrified peaceniks by announcing that he had relaunched a Cold War effort to have a fleet of nuclear-capable strategic bombers in constant flight. The Russian president also recently blasted U.S. plans to put an anti-missile defense battery in Poland and the Czech Republic, which are two of Russia's old Warsaw Pact allies.

And, of course, Putin is at odds with Great Britain over the radiation poisoning of dissident KGB agent Alexander Litvinenko in London last year, with each side refusing to cooperate in the other's investigations. Taking the tit-for-tat up another notch, Putin has lately engaged in a row with Estonia over dissident arrests, threatened to cut off gas supplies to Belarus and withdrawn from a key disarmament pact known as the Treaty on Conventional Armed Forces in Europe.

Stratfor

, a geopolitical think tank, has speculated that Putin wishes to have a confrontation now rather than later, as his country is demographically doomed with a low birth rate and soaring death rate.

Stratfor analysts say that the Russian population is thinning by about 750,000 people per year just as the average Russian grows older and, therefore, less productive -- and they further estimate that by 2050 the country's population will have decreased by a third, or 140 million people. They conclude that as a country, Russia is quite literally dying, and therefore its leaders believe they must stake out their territorial objectives now, before it's too late.

While I can't speculate any further on Putin's motives, I do feel confident that his efforts will spark retaliatory rhetoric and arms spending here in the U.S. The easiest way to participate as an investor is to buy one of the two exchange-traded funds focused on U.S. defense:

iShares Dow Jones U.S. Aerospace and Defense

(ITA) - Get iShares U.S. Aerospace & Defense ETF Report

and

PowerShares Aerospace and Defense

(PPA) - Get Invesco Aerospace & Defense ETF Report

. They're up 51% and 44%, respectively, over the past 20 months.

The cheapest and best-managed two individual contractors, in my opinion, are

Lockheed Martin

(LMT) - Get Lockheed Martin Corporation (LMT) Report

and

General Dynamics

(GD) - Get General Dynamics Corporation (GD) Report

. All should be on track for 18% to 22% annual gains over the next three to five years, no matter what happens in the broader financial markets.

At the time of publication, Jon Markman owned shares of Lockheed Martin.

Jon D. Markman is editor of the independent investment newsletter The Daily Advantage. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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