Defense Stocks to Watch: Why Gains May Continue Beyond Initial Estimates

The defense sector has delivered exceptional gains over recent months, and market observers believe the upward trajectory may still be in its early phases. Equities within aerospace and defense—tracked through instruments like the State Street SPDR S&P Aerospace & Defense ETF (NYSE:XAR)—have experienced nearly 100% appreciation since April 2025 lows, outpaced only by precious metals mining. For context, the current 10-month rolling performance now rivals the rebound witnessed following March 2009. With such dramatic movements, investors must evaluate whether defense stocks represent genuine opportunity or inflated valuations chasing momentum.

The Structural Shift in Global Defense Spending

The fundamental story supporting defense stocks gains appears remarkably durable. According to Bank of America equity research shared recently, the world is witnessing a “new modern age” in defense posture and capability development. Global defense expenditures are accelerating at an unprecedented rate. U.S. defense appropriations have crossed the $1 trillion threshold, while NATO members are repositioning toward 3.5% of gross domestic product allocated to core defense requirements by 2035—a dramatic shift from current levels. Should non-U.S. NATO nations achieve this spending target, approximately $370 billion in incremental annual expenditure would flow into the system.

This structural reorientation stems from multiple pressures: depleted missile and munitions stockpiles after sustained support for Ukraine and allied operations, persistent Middle East tensions, Russia’s continued aggression in Eastern Europe, and intensified strategic competition in the Pacific region. These aren’t temporary concerns but represent an extended threat environment reshaping defense priorities for years ahead.

Defense Budgets Climbing Faster Than Expected

Bank of America analyst Ronald Epstein highlighted shipbuilding and integrated air and missile defense systems as primary growth vectors. Initiatives such as the “Golden Dome” program exemplify the modernization trajectory. Prime contractors including Northrop Grumman Corp. (NYSE:NOC), RTX Corp. (NYSE:RTX), and L3Harris Technologies Inc. (NYSE:LHX) are positioned as principal beneficiaries of this spending wave.

Recent projections offered intriguing potential. At a Defense Outlook Forum, retired General Arnold Punaro expressed confidence that U.S. defense budgets could expand to $1.5 trillion—representing a 50% increase versus fiscal 2026 estimates. Skeptics note Congress faces roughly $42 trillion in federal deficit challenges, creating constraints on such dramatic expansion. Nevertheless, the directional consensus appears settled: defense spending trajectories point upward, not downward. The question concerns magnitude and timing rather than direction.

AI and Autonomy: The Next Competitive Advantage for Defense Contractors

Future warfare will diverge substantially from historical patterns. Bank of America emphasizes that automation, autonomous systems, and artificial intelligence represent non-negotiable elements across contemporary combat domains. Defense establishments are actively pressuring contractors to expand manufacturing capacity, reduce per-unit costs, and establish enduring software advantages. This technological imperative creates distinct winners and laggards among defense stocks.

Epstein noted that contractors successfully integrating AI across enterprise operations and battlefield applications could achieve profit margins approaching those of commercial aerospace or technology sector companies. This represents a material upside scenario for businesses that execute effectively. The companies lagging in digital and autonomous capabilities face margin compression and potential market share erosion—a powerful incentive structure driving near-term investment in these technologies.

Valuations vs. Earnings: Are Defense Stocks Fairly Priced?

A near-doubling of sector valuations naturally invites scrutiny regarding excess. However, unlike speculative technology rallies driven primarily by sentiment, the defense sector rally demonstrates deeper economic underpinnings. Governments have committed to multi-year budget increase programs. Geopolitical tensions persist across multiple regions without apparent resolution mechanisms. Global missile and ammunition inventories remain significantly depleted. Defense has achieved clear policy priority status among U.S. and NATO leadership.

Critically, valuation expansion has accompanied robust earnings growth rather than preceding it. Defense contractors report expanding order backlogs and increasing production capacity utilization. As new contracts flow into the system and existing backlogs convert into revenue recognition, earnings estimates continue climbing. This pattern suggests valuations may reflect economic reality rather than speculative overreach.

If Bank of America’s analysis proves prescient, investors may be observing the foundational stage of a multi-year structural upcycle rather than witnessing an exhausted tactical bounce. The intersection of sustained policy commitment, depleted inventories, technological imperative, and expanding capacity creates a durable framework for defense stocks performance extending well beyond current levels.