Sequestration Could Put Defense Stocks In Limbo For Months

Robert Ewers of Height Analytics put out a note on November 16 suggesting that full-scale sequestration of defense funds under the Budget Control Act is unlikely to occur given the devastating consequences. Among the consequences he cites are a ten-percent year-over-year decline in fiscal 2013 military outlays (including a “high teens” cut in investment accounts) and the destruction of 600,000 jobs. Ewers shares the view of White House budget director Jacob Lew that the political system can’t live with the results of automatic cuts, and thus that it will act to avert them.

He’s probably right, but the note contains an unsettling aside about what would happen to defense equities if full sequestration actually was implemented: “If you believe this scenario plays out, the defense complex is an obvious short in our view, because even the current low valuations do not reflect the tremendous effects of sequestration.” In Wall Street parlance, short selling means betting that a stock will go down. You borrow shares and sell them, then buy new shares to return to the original owner later; if the stock goes down during the intervening period, you pocket the difference between the price at which you sold them and the price you had to pay to rebuy them.

So short selling signals pessimism about the outlook for a company or sector, and there’s a high likelihood sequestration could lead to widespread short-selling of defense shares. If Congress then moves to head off massive cuts in military spending, that could send investors on a roller-coaster ride that would put both shareholders and short sellers at risk. As if this were not bad enough, though, there’s a third scenario that might play out for a year or longer: the sequester is triggered, and then Congress fails to avert cuts until after the November 2012 elections. This possibility arises because although we could know within days that a sequestration has been triggered, under the law the actual cuts don’t begin happening until January 2013. Congress thus has over a year to mill around after sequestration has been triggered before it absolutely, positively must act to prevent damage to the nation’s defense posture.

Congress generally waits until the last minute to do everything, and that trait will probably be magnified in an election year. So defense shares could end up in limbo for much of 2012, with investors unsure how to act. On the one hand, they would know a budgetary sword of Damocles was hanging over the sector, ready to plunge in January of 2013. On the other hand, they would be getting constant reassurances from legislators and analysts that, no, the political system will never let that happen. The result would be some very complex trading strategies, but on balance probably a depressive effect on share prices. Prices would surge as soon as the threat of sequestration was lifted, but who knows when that would happen — if it happens at all. Let’s keep in mind here that some sizable shareholders in the sector don’t understand very well how the political system works, so they won’t exhibit the patience of a Fidelity or Wellington when it comes to the disposition of their shares.

The bottom line is that the Budget Control Act isn’t just a threat to jobs and national security. It will impair the capacity of the defense industry to raise capital and function effectively even if any sequestration is eventually headed off. Budget Director Lew certainly got it right when he said in an August 4 blog posting on the White House web-site that the sequester was “meant to be an unpalatable option that all parties want to avoid.” The question defense investors face if the congressional super-committee fails, though, is what to do in the period between when automatic cuts are triggered and the political system comes to its senses.