There's no two ways about it: Defense stocks have been terrible for months. Now, with Wall Street seeing new opportunities in the sector, investors still look nervous.
If you're looking for reasons for that trepidation, forget the "Blue Wave" dilemma. Investors are probably just tired of the chaos.
Coming into Wednesday trading, shares of major contractors Lockheed Martin, Northrop Grumman, L3Harris Technologies, and General Dynamics were down an average of 25% since the start of the Iran war in late February.
Shares of drone technology companies Kratos Defense & Security Solutions, Karman, and AeroVironment were down an average of 48% in that time. Shares of Boeing and RTX, which also have large commercial aerospace businesses, were down 18% and 10%, respectively. All that happened while the S&P 500 advanced 13%.
The defense declines came despite a major effort to expand U.S. missile production, providing a sales benefit to most of the sector for years to come. Drone technology's importance also continues to grow. Still, at the start of 2026, drone maker Kratos' shares traded at 160 times earnings expected over the coming 12 months. They trade at 38 times now.
Earnings haven't been the problem. Wall Street projects 2027 earnings per share of $1.10 for Kratos. A year ago, that estimate was $1. The pattern is similar for large contractors, too. Lockheed is expected to earn $32.75 a share in 2027. A year ago, that estimate was closer to $31.
The most common explanation for weakness is that a Democratic sweep in the midterms could lead to lower military spending.
"The sector's performance has a striking correlation with the disapproval rating of President Trump and the odds that the GOP loses control of the Senate in November," says Vertical Research Partners analyst Rob Stallard. Recent polling shows a net approval rating of minus 26%.
"Polymarket odds show a 65% chance that the Democrats take the Senate -- the House probability stands at 93%," adds Stallard.
Still, 2027 spending should be $1.2 trillion, even with a split Congress, budgetary pressure, and higher bond yields. That's enough to support defense stocks, leaving the "Blue Wave" theory unsatisfying.
Another potential problem is a memo from Deputy Defense Secretary Steve Feinberg that proposes changes to contract negotiations and accounting. Investors clearly fear that means lower profit margins down the road.
Defense margins, however, aren't excessive, relative to the market. Lockheed is expected to produce an operating profit margin of 12% in 2026. Caterpillar is expected to produce a 20% margin.
"Not as bad as it seems," wrote TD Cowen analyst Roman Schweizer, shortly after the memo was released. More transparency, easier accounting, and streamlined bids can make things easier for the industry -- eventually.
The biggest problem might be overwhelm. Investors are dealing with changing policies, changing policy priorities (I.e., drones over jets), and multiple wars while the Pentagon tries to shift the production of critical components away from China.
Things feel chaotic. Investors hate uncertainty, and fear can drive down multiples of any stock or sector, as it did with Alphabet during its antitrust trial or software stocks in the 2026 SaaS-pocalypse.
The selloff in defense stocks has brought valuations back to normal levels. Stallard says current valuations imply 6% military spending growth, which is a reasonable expectation.
He upgraded Lockheed Martin shares to Buy from Hold on Wednesday. He left his price target unchanged at $600, up almost 20% from recent levels.
"It's not that bad," says Stallard. Investors aren't so sure.
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