David Sterman

Circle your calendars for Nov. 23. That's the deadline for Congress to pass -- and the President to sign -- major budget changes being drawn up by a bipartisan "super-committee." Recall that the last agreement, struck in early August, tasked this group with a huge challenge: Come up with a wide range of chosen budget cuts, or live with the consequences of automatic spending cuts that leave no stone unturned.

That's bad news for investors, as we could see history repeating itself in a very unpleasant way.

At this point, Democrats and Republicans are far from an agreement. Democrats have offered up $3.2 trillion in spending cuts, paired with $1.3 trillion in new taxes. Republicans are fine with the spending cuts but insist on no new taxes. Neither side looks ready to blink so far, and it's increasingly looking as if the automatic cuts will be the path.

This is horrible news for the defense sector and investors who hold stocks in these companies. Cuts in military spending already have the support of most Democrats, but a rising number of deficit hawks in the Republican Party are willing to trim Department of Defense (DoD) spending as well. Still, a negotiated budget will be far friendlier to the DoD than the automatic cuts that may take place on Nov. 23. How much are we talking about? About $454 billion from the next DoD budget. That's more than one-third of all planned automatic cuts that would take place. And these cuts come on top of $350 billion in previously agreed-upon cuts as a result of this summer's budget agreement.

The number of soldiers on active duty would likely have to shrink, but it's impossible to quickly shed tens of thousands of soldiers, shutter dozens of military bases and withdraw from key strategic regions around the world. This is a long-term possibility, but not a short-term one. Instead, look for the budget axe to come down hard on defense contractors, all of whom live off lucrative contracts to build billion-dollar planes, ships and security systems. Merrill Lynch says spending by defense contractors will shrink 3.3% annually for the next five years -- and even this number may prove optimistic. Defense spending has risen from 3% of gross domestic product in the 1990s to a current 4.8%. A return to that 3% level represents a 35% drop.

David Sterman

David Sterman has worked as an investment analyst for nearly two decades. He is currently an analyst for StreetAuthority.com

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