Citi cautions clients about chasing defense stocks at these levels even with Trump's big spending plans

F-35 Bravo Lightning II stand ready on the deck of amphibious assault ship USS Wasp for day two of the first phase operational testing in the Atlantic Ocean in this handout photo taken May 19, 2015 and provided by the U.S. Navy.
U.S. Navy | Reuters

Citi Research on Wednesday cautioned clients about chasing defense stocks at the current levels, citing stretched valuations and limited upside potential despite expectations for higher military spending under President Donald Trump.

The firm downgraded Northrop Grumman and General Dynamics to neutral from buy.

"After nearly seven years with a positive bent on defense stocks we are now turning more neutral on the group," equity analyst Jason Gursky wrote in a research note. "This shift is driven by a potential disconnect in investor expectations for industry growth & by potential pressure on historic business models. We don't think the sector underperforms indices going forward per se; it's just that it's reaching fair value," he said.

The report was released after White House officials on Monday told reporters of a budget proposal calling for a $54 billion increase in defense spending next year. In a speech to Congress on Tuesday night, Trump called for one of the largest increases in defense spending in American history.

Given expectations of what the new administration might be able to accomplish, Citi says defense stocks have already run up, and are now trading at multiples the firm considers to be "aggressive."