U.S. defense stocks lost ground in March even as hostilities involving Iran continued, a pattern that suggests the market's initial bid tied to the prospect of wider conflict had largely played out before heavy fighting unfolded. The NYSE Arca Defense index, which covers 34 U.S. defense companies across the market-cap spectrum, fell nearly 8% in March versus a roughly 5% drop for the broader S&P 500.
That dynamic contrasts with the market response seen in other major conflicts - for example, the defense index jumped about 12% in February 2022 when Russia invaded Ukraine - but this time strategists say much of the upside arrived in the run-up to the current war as investors moved to position themselves for a higher probability of tougher action.
Analysts noted that the recent pullback does not necessarily indicate fading demand for defense products or doubts about sustained defense budgets over the longer term. Rather, it appears to reflect investors reducing positions after a strong advance earlier in the year.
"A lot of conflict premium was in their valuations," said David Bianco, Americas chief investment officer at DWS. He pointed to concurrent rallies in gold and oil as part of the same market reaction, and connected the rise in defense shares to early signals from the administration when military assets were deployed toward the Middle East.
Bianco added that he had already trimmed his overweight exposure to defense stocks before the most recent conflict began, underscoring the view that some investors anticipated the risk and bid securities higher before operations escalated.
Signs that the U.S. was preparing for a possible confrontation appeared in market pricing well before U.S.-Israeli strikes began in late February, with military build-ups and operational planning contributing to investor expectations of a protracted engagement if diplomacy failed.
European defense stocks also saw heavy selling pressure. The European defense sector fell 11% in March, its largest monthly decline since the pandemic, amid a broader market sell-off and investor worries about potential energy shocks linked to the conflict. Those shares had earlier enjoyed a lengthy rally as governments in Europe announced major rearmament plans following Russia's actions in Ukraine.
At the policy level, proposals for larger U.S. military spending have been floated, but uncertainty persists about what legislative outcomes will be. Earlier this year, a proposal put forward called for a $1.5 trillion U.S. military budget for 2027 - a figure well above the $901 billion approved for 2026 - yet questions remain about Congress passing such an increase.
"Nothing that has happened so far suggests that a $1.5 trillion 2027 defense budget could be exceeded. For these reasons, one should not expect upside to come from the current conflict," Bernstein analyst Douglas Harned wrote in a recent note.
Valuations in the sector are elevated. Between 2020 and 2025 the defense index surged by more than 150%, leaving many names trading at historically high multiples. LSEG data show the S&P 500 Aerospace & Defense sub-index trading at about 32 times 12-month forward earnings, compared with the broader S&P 500 multiple of roughly 20 times.
Market reaction to Pentagon efforts to increase output and replenish missile and ammunition stockpiles has been muted. Analysts point out that any revenue gains tied to higher demand will take time to show up in company results because of long production cycles and existing capacity limits that prevent rapid scale-up.
Expectations for 2026 earnings growth for major defense contractors - General Dynamics, Lockheed Martin, Northrop Grumman, L3Harris and RTX - were around 12% at the end of March, down from roughly 15% at the start of 2026, according to Tajinder Dhillon, head of earnings and equity research at LSEG Data & Analytics.
Sameer Samana, head of global equities at Wells Fargo Investment Institute, said that the conflict would need to be longer-lasting or materially larger for those earnings estimates to be revised higher.
Aside from valuation and earnings considerations, investors are also weighing supply and policy constraints. Richard Safran, senior analyst and managing director of aerospace and defense at Seaport Research Partners, noted that during conflicts defense firms often divert funding to immediate operational needs, which can reduce spending on modernization and development projects.
Additionally, the administration has been urging defense contractors to prioritize production increases over shareholder returns, adding uncertainty around capital allocation and dividends or buybacks. The medium-term trajectory for the sector hinges in large part on U.S. budget decisions; important spending details are expected on April 21.
For now, the market picture for defense stocks is one of tempered expectations. A strong pre-conflict rally, elevated valuations, constrained near-term production flexibility and outstanding fiscal questions have combined to limit further upside from the ongoing war.