Defense stocks are on the offensive.
Investors seem to be betting that the U.S. defense industry has so far waged a successful campaign against looming budget cuts to secure a profitable peacetime footing after a decade of war.
But it remains to be seen whether these companies can offset tens of billions in shrinking orders for swords with new, long-term contracts for plowshares.
For the moment, investors seem to be overlooking expected cuts in military spending. As defense contractors continue to churn out solid earnings and dividends, their stocks are reaching new highs. Teledyne Technologies, Boeing, Northrop Grumman and United Technologies have hit record highs. Lockheed Martin, General Dynamics and Rockwell Collins are within 10 percent off their all-time peaks.
Analysts say several powerful forces are at work offsetting the heavy headwinds of military spending cuts.
(Read more: How Boeing came back from the brink)
For one thing, many of these companies squirreled away large piles of cash during the boom years knowing that the wartime spending surge wouldn't last forever. At a time when record low interest rates have left investors with few places to find a reliable return, those balance sheets are helping to fund a steady stream of dividends and stock buybacks.
"(These stocks provide) good cash returns to shareholders at a reasonable price where other higher yielding groups are a lot more expensive," said Carter Copeland, a defense industry analyst at Barclays.
As Pentagon spending has slowed, the defense industry has also been beefing up commercial contracts with civilian customers to offset the squeeze brought by the drawdown of two wars and Washington's ongoing deficit cutting.
As military orders have peaked, for example, demand for commercial aviation is taking off. Since the global economy began pulling out of the deep nosedive of the Great Recession in 2010, airlines around the world have been expanding capacity and looking to cut rising fuel costs by replacing aging fleets of gas guzzlers with high-efficiency aircraft, according to a recent report by Deloitte. Boeing estimates that over the next two decades, more than 35,000 new airplanes will be built, driving production to record levels, according the report.
Demand for those new airplanes—and the parts and electronics needed to make them—has helped boost the aerospace and defense industry's overall share of revenue coming from commercial orders. Last year, defense orders accounted for just 54 cents of every dollar of industry revenue, down from 60 cents in 2010.