Defense stocks have quietly staged one of the most powerful rallies in recent memory, and according to Wall Street analysts, we might still be watching the opening act rather than the finale.

The State Street SPDR S&P Aerospace & Defense ETF (XAR) has rocketed nearly 100% since hitting bottom in April 2025. That's a stunning move by any measure. Only gold miners have managed to post stronger gains over the same period. The current 10-month rolling return for defense stocks now exceeds even the surge that followed the market bottom in March 2009.

Which naturally raises the question every investor should be asking: has this thing gone too far, or are the fundamentals actually justifying the rally?

Defense Budgets Are Climbing Fast

Bank of America equity analyst Ronald Epstein described the current defense environment in a Thursday note as nothing less than "the rise of a new modern age." That's not typical Wall Street hyperbole, either.

Global defense spending is accelerating across the board. The U.S. defense budget has crossed $1 trillion for the first time. Meanwhile, NATO countries are moving toward a target of spending 3.5% of gross domestic product on core defense by 2035. If the non-U.S. NATO members actually hit that 3.5% target, we're looking at roughly $370 billion in additional spending, according to BofA Global Research.

Epstein sees shipbuilding and air and missile defense systems as particularly strong growth areas. He specifically called out initiatives like the "Golden Dome" as key priorities. There's a straightforward reason for this: missile and munitions stockpiles remain seriously depleted after years of supporting Ukraine and other allies. Inventories need to be rebuilt, and that takes time and money.

The bank expects prime contractors like Northrop Grumman Corp. (NOC), RTX Corp. (RTX), and L3Harris Technologies Inc. (LHX) to benefit the most from this spending wave.

Could the U.S. Budget Hit $1.5 Trillion?

At a recent Defense Outlook Forum hosted by Bank of America, retired Gen. Arnold Punaro expressed optimism that the U.S. defense budget could eventually grow to $1.5 trillion. That would represent roughly a 50% increase compared to fiscal 2026 levels.

Not everyone thinks that jump is realistic. Analysts Doug Berenson and Todd Harrison pointed out that major top-line growth might be difficult to achieve when Congress is staring down a roughly $42 trillion federal deficit.

Still, the directional trend seems clear: higher, not lower. The threat environment remains elevated across multiple fronts. Tensions in the Middle East persist. Russia's war in Ukraine continues with no end in sight. Strategic focus on the Pacific is intensifying as China expands its military capabilities.

AI and Automation: The New Battlefield

Here's where things get interesting from a technology perspective. Future wars won't look anything like past conflicts, and Bank of America is highlighting the growing importance of automation, autonomy, and artificial intelligence across all war-fighting domains.

The Department of War is actively pushing contractors to improve output, lower costs, and build an enduring software advantage. Autonomous systems and enterprise-level AI adoption aren't nice-to-haves anymore. They're becoming non-negotiable requirements.

According to Epstein, defense contractors that successfully integrate AI at both the enterprise level and on the battlefield could achieve profit margins closer to what we see in commercial aerospace or technology companies. That would represent a significant expansion in profitability for an industry that has traditionally operated with tighter margins.

Have Defense Stocks Moved Too Far?

A nearly 100% rally naturally raises valuation concerns. Nobody wants to be the investor who buys at the top of a momentum-driven surge.

But unlike speculative tech rallies driven purely by narrative and sentiment, this move appears grounded in actual fundamentals. Governments are committing to multi-year budget increases with specific spending targets. Geopolitical tensions remain elevated across multiple regions, from Europe to the Middle East to Asia. Global missile and munitions inventories are genuinely depleted and need to be replenished. And perhaps most importantly, defense has become a clear policy priority across the U.S. and NATO allies in a way it hasn't been for decades.

Valuations have definitely risen, but earnings estimates are climbing right alongside them as order backlogs grow and production capacity expands. Companies are securing long-term contracts with solid visibility.

If Bank of America's analysis is correct, investors may still be witnessing the early phase of a structural upcycle rather than the exhausted final leg of a tactical bounce. The fundamentals supporting higher defense spending aren't going away anytime soon, and the companies positioned to benefit are seeing real business momentum, not just stock price appreciation.