Looking at the BAE Systems (LSE:BA.) share price in 2026, I’m reminded of investor Ray Dalio’s quote: “He who lives by the crystal ball will eat shattered glass“.
That’s because at the end of last year, I peered into my crystal ball and predicted that defence stocks in 2026 would have a quieter year.
This came when BAE stock was on course for a 52% return in 2025, with Babcock International performing even better (up almost 150%!).
I based my prediction on the fact that a Ukraine peace settlement seemed to be inching closer, while negotiations for the UK to join the EU’s new €150bn defence fund officially collapsed.
Meanwhile, the stock looked fully valued at around 25 times earnings.
Yet I’ve been proven totally wrong so far, with the BAE share price rocketing almost 23% year to date! Babcock’s up 19%.
Clearly, I need a new crystal ball!
What’s going on?
Global defence stocks were boosted significantly earlier this month when President Trump suddenly called for a massive increase in the US military budget. He said it should be $1.5trn in 2027, up from $901bn this year.
Almost half of BAE’s revenue comes from the US, so any huge increase in spending in its largest market would obviously be a bullish development for its sales pipeline.
Also this month, there has been the US operation in Venezuela and a geopolitical crisis around the future of Greenland. The latter has sent European defence stocks soaring to their best-ever start to a year.
Investors are betting that US pressure on Denmark to sell Greenland will cause European governments to prioritise defence spending more than ever. In particular, that they will favour domestic continental suppliers to protect themselves from unpredictable US policy.
In November, BAE won a $450m contract to deliver 44 extra CV90 combat vehicles to Denmark. And in August, it signed a £10bn deal with Norway to supply five new warships. But the company’s also continuing to pick up regular contracts from the US military.
High valuation
Now, I should clarify that I’m not bearish on defence stocks. Far from it, as I remain a BAE shareholder myself.
In fact, I recently named this FTSE 100 stock as one of two long-term ideas to consider for an ISA/SIPP after a 17.5% pullback (the other was Novo Nordisk). I just thought 2025 would be more lowkey (not further fireworks).
However, with the share price soaring to new highs this month, it’s worth noting the valuation here. We’re looking at a price-to-earnings (P/E) ratio of 32, which is higher than this metric has been in recent years.
In December 2024, for example, the forecast P/E multiple was 18 versus 25 today. And the forward-looking dividend yield now is less than 2%, meaning there’s not much income on offer for new investors.
If Trump dials down the Greenland rhetoric and removes the threat of tariffs, the stock could pull back sharply as investors book profits.
With the stock up 23% in less than three weeks, investors considering BAE Systems might want to wait for a pullback. Personally, I see better ideas elsewhere for my own portfolio.
