The productivity tools employed by the military will continue to be called upon to actively engage local insurgencies but more importantly to deter large-scale conventional or nuclear war with increasingly aggressive China and Russia. Downsized and under-funded beyond reason in the 1990s, the highly capable U.S. military has seen the greater resources accorded it during the 2000s expended in fighting low-level conflicts not just in the Middle East and Central Asia but at lower intensity, less publicized levels around the globe. Even as some modernization in key weapons systems has taken place from the materially higher defense budgets of the last seven years, much of the funding increment has gone for training, readiness, logistic support and stockpile rebuilding.

The numbers of front-line fighter aircraft and naval vessels have continued to shrink but even if these have not borne the brunt of combat in Iran or Afghanistan, without them China and Russia will be accorded far freer reign than will prove palatable to western sensibilities. This can already be seen in recent Russia moves in the Balkans with respect to Serbia and Kosovo independence, as well as in the open funding of Georgian separatism and forays into the Arctic Circle. China’s crackdown on Tibet and other ethnic minorities along with a quest for energy and natural resources challenges neighboring states, particularly those with oil and materials.

To meet the challenges of the next half century, a wholesale turnover of key weapons systems is called for to replace a rapidly aging capital stock largely funded thirty-forty years back. While America’s military buildup of the 1980s was inordinately successful in ending the threat posed by the USSR, it was largely strategic nuclear in scope and resulted in fewer conventional, nonnuclear forces than in the three decades since World War II. “Peace divided” cutbacks in the 1990s after the first Iraq War continued to reduce the scope of U.S. fighter aircraft, surface combatants, attack submarines and submarine based strategic nuclear deterrent. China’s rapidly paced military buildup now dates some fifteen years, largely in response to the rapid economic growth sparked by determination to not follow the also Communist USSR into oblivion.

Should the absolute size of U.S. and allied militaries be increased as we believe necessary, then the prospective market growth the next half dozen years will be all the greater. We believe such a likelihood all the greater should Senator McCain win the White House in the upcoming November election, the odds of which we believe have been improved by recent events. Election of the Democratic nominee would likely result, as with the prior two elected Democratic Presidents, in reversal of strong election talk of supporting the U.S. military into a governing posture of reducing defense outlays. Particularly affected would be monies particularly for strategic weapons systems and advanced engineering development comprising future revenue and earnings streams of the companies we follow.

Built-in delays in how Congress appropriate funds, then the time frame for them to be spent means a necessary continuation of moderate growth for defense companies into 2009-10 because of defense bills that will be passed prior to the conclusion of the Bush Administration. However, the trajectory of spending, hence revenues and earnings in the 2010-14 period which investors are today evaluating on whether to buy or sell the defense pure-plays, and even many of the defense-commercial hybrids, will be acutely impacted by which party’s candidate moves into the oval office in January 2009. Hence, even if near-term earnings estimates are not affected by this upcoming November’s result, the P/Es and EV/revenues at which the stocks sell will be materially impacted by the future course of spending. Valuations will rise if McCain wins; they will contract if Obama gains victory.