Defense stocks usually tend to be among the first beneficiaries of a geopolitical crisis. However, as the U.S.-Israel war in Iran has no end in sight, the traditional market response is missing. ETFs that track defense stocks, such as the SPDR S&P Aerospace & Defense ETF (NYSE:XAR) and the iShares U.S. Aerospace & Defense ETF (BATS:ITA), are trading down, defying the traditional investment approach of "buying defense stocks during a war." The funds are down more than 9% and 10%, respectively, since the war began.

A Crowded Trade Meets Reality

The early stages of the conflict have already cost the world nearly $11 billion, according to the Wall Street Journal, primarily due to missile-defense expenditures, such as the deployment of Patriot and THAAD missiles.

The WSJ is also reporting that the U.S. is deploying additional warships and thousands of Marines to the Middle East (13 U.S. military personnel have been killed, and at least 200 U.S. troops have reportedly been wounded).

Shares in defense leaders such as Lockheed Martin Corp (NYSE:LMT), RTX Corporation (NYSE:RTX), and Northrop Grumman Corp (NYSE:NOC) have traded sideways or down since the onset of the conflict.

One reason is that defense stocks have already risen 50% since the mid-2024 Trump-Biden debate, as noted by the WSJ. As a result, valuations are near their historical highs, and defense stocks are no longer reacting as much to geopolitical tensions.

Shifting Economics Of Warfare

The conflict is also exposing a further underlying trend: the shifting economics of modern warfare. Here, the US and its allies are deploying multimillion-dollar missile defense systems to counter low-cost drones.

This is prompting a rethink of defense strategies, and there is growing interest in cheaper, tech-driven solutions such as drones, artificial intelligence, and space-based defense. This is creating a potential headwind for traditional defense contractors, whose business models still rely heavily on traditional defense spending.

The divergence in defense ETFs reflects this shift in the defense space. The XAR, which follows an equal-weight approach and offers greater exposure to smaller, emerging defense tech firms, has risen almost 60% over the past year. Meanwhile, the more top-heavy ITA, dominated by large primes, has lagged, gaining about 44% in the past year.

Not A Straightforward War Trade

Policy uncertainty is another factor affecting investor sentiment. The Trump administration is expected to impose stricter regulations on defense contractors, including curbs on share buybacks and dividends, until performance targets are achieved. Higher capital expenditure requirements could negatively impact earnings.

While rising global defense spending and subsequent missile replacement orders will continue to support the sector, the conflict with Iran is proving to be a more complex catalyst for the defense sector.

Instead of launching a broad-based rally, it is highlighting valuation limits and accelerating the move into next-generation defense technology, leaving traditional defense ETFs caught in the crosscurrents.

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