Good securities?

The world is becoming increasingly militarised. Bad news for peace, good news for the continuing defence stocks bull run. All the world's major defence companies have been doing extremely well, some trebling their share values over the past few years.

Armor Holdings, a manufacturer of military vehicles, armoured Humvees and bullet-proof vests, has been the market's most notable performer. This can be attributed to strong demand for military vehicles that can withstand repeated roadside bombings and insurgent attacks in Iraq and Afghanistan. Its share price spiked in May this year after BAE Systems announced a $4.5 billion takeover deal of the company. Armor should continue to perform well until the deal closes this year: BAE said at the time of its purchase that there was increasing demand among coalition forces in Iraq for better-protected military vehicles and said that 60% of the US Army's current stated medium truck requirements were still to be manufactured.

Companies that manufacture for both the military and civilian commercial sectors have also reaped rewards. Leading Pentagon contractors Lockheed Martin and Northrop Grumman have hit all-time highs in the past few weeks. The same goes for Boeing, which makes military jets and weapons systems as well as commercial airliners, and General Dynamics, which owns corporate jet maker Gulfstream in addition to its core defence businesses.

One half of the bull run story is the defence budget of the United States. For 2007, its budget was raised to a total of $532.8 billion, which does not include the cost of the wars in Iraq and Afghanistan, which have been largely funded through extra-budgetary supplements. The US Army is showing the greatest growth, with spending up as much as 20% over last year. This benefits companies like L-3 Communications Holdings, the maker of military electronics.

The other half of the story is the arms race developing outside the United States. Fuelled by high commodities prices and rising political unrest, spending on arms is on the rise all across the globe. Huge orders for arms have come from Saudi Arabia, Chile, Brazil, Japan, Jordan, Greece, and South Korea.

Possible constraints?

The only visible constraint on defence firms appears to be their increasingly high valuation relative to other stocks. There is also a feeling that the easy dollars have already been made, as expectations of a surge in Iraq were already written into companies' stock prices.

Another major concern for investors is the delay to large defence programmes if the US winds down activities in the Middle East. But Washington will still have to upgrade and modernise existent equipment. India and Japan are also modernising their military. In the case of economic downturn, the long timescales of arms programmes mean that any changes to spending will not immediately have an impact. Few governments will want to abandon modernisation programmes once they have embarked on them.

In the short and medium-term, defence stocks still look a safe bet. The sector's performance is not yoked to movements in the broader market, but instead depends on political events and domestic security policies. US spending cuts in the next year or two seem very unlikely, as Democrats will not want to appear a soft touch on security ahead of the 2008 presidential election.