Headlines screaming, “fire and fury,” and “ballistic rockets are on constant standby,” could have surely warranted a multi-percentage sell-off. Fortunately, the market’s reaction was somewhat muted, falling just over 1 percent for the week. Historically, North Korean headlines have had minimal impact on the stock market. In 2006, when they detonated their first nuclear device, U.S. stocks were actually up.
The drawdowns we saw this week are quite common for the stock market, especially since we are still close to an all-time high. Thursday’s sell-off of 1.4 percent was not out of the ordinary, with or without the rhetoric in the headlines. Volatility in the equity market has been relatively low this year and a meaningful price move was due. In fact, it had been 60 trading days, May 17 to be exact, since stocks have retreated more than 1 percent. Stocks have only moved up-or-down more than 1 percent in a day now five times this year, which collectively is 3 percent of trading days thus far in 2017. Since 1978, during any given year, stocks will move more than 1 percent a quarter of the time, as seen in the chart below.
While all the saber-rattling can be unsettling for the public, it is no surprise that these developments are benefiting defense contractors. Recent comments from management teams have shown a meaningful increase in interest and orders globally. Raytheon's management has stated that it is unusual to see such a growth in demand from multiple regions around the world. In November of 2016, we had increased our exposure to defense contractors due to the belief that a Republican government would continue increase spending on national security. Recent terror events and North Korea escalations have led to more strength in the sector. The chart below compares the performance of the defense contractors versus the S&P 500 since the election. While the market is up 15 percent, defense names are up 33 percent.
Finally, we believe it is too early to change portfolio allocations in light of current headlines. The rhetoric toward North Korea is not unique to President Trump. President Clinton conveyed a similar tone in 1993, as seen in this New York Times article, which also occurred early in his presidency as we are experiencing with Trump. We believe the banter will cool down over time and markets will once again focus on economics. In the near-term, headlines may trump fundamentals, particularly in light of us entering what is often the weakest period for stocks in the calendar year.
Takeaways for the Week
- Although short-term weakness may prevail, we are still bullish are equities
- Defense stocks should continue to benefit in the current geopolitical environment