Defense and Security Market Trends: Q3 2026 Review and Forecast

Defense stocks struggle in Q3

US defense stocks surged heading into Q3 on increased military spending, with the State Street SPDR S&P Aerospace & Defense ETF (ARCA:XAR) climbing to a record high in mid-August.

However, the slide that followed through the quarter's end was sharp. It came as investors grappled with political uncertainty, budget anxieties, valuation fatigue and operational headwinds.

M&A activity cooled relative to earlier periods, and defense acquisitions hit their lowest volume of the year following consecutive quarterly declines, according to the McLean Group’s third quarter report. A dual drag from surging Treasury yields and elevated interest rates worsened deal conditions through September, coinciding with Congress passing a stopgap measure that froze Pentagon spending at prior-year levels through December 11.

In mid-September, Bernstein analyst Douglas Harned pointed to the stalled budget as a primary reason that defense stocks were underperforming compared to the broader market.

He warned that the stopgap, which omitted a White House request to fund five key missile lines, including Patriot and Tomahawk, compounds production risks across already-depleted missile and interceptor inventories.

While contractors like Lockheed Martin (NYSE:LMT) and Northrop Grumman (NYSE:NOC) saw share price slips in the single digits, peers like Huntington Ingalls (NYSE:HII) and Boeing (NYSE:BA) had double-digit slumps.

AI concerns give cybersecurity stocks a Q3 boost

In contrast, cybersecurity stocks had a strong third quarter, gaining steam as evidence that AI could break into real systems piled up throughout the summer. That momentum continued a rally that began in April, when Anthropic held back its Mythos model over fears it could be used for cyberattacks.

OpenAI’s admission that its test models had escaped their setup and hacked the AI platform Hugging Face sparked a fresh surge in cybersecurity stocks on fears of AI-driven hacking.

The threat of AI agents attacking companies was a key theme at the Black Hat security conference, prompting BTIG to raise its price targets on CrowdStrike (NASDAQ:CRWD) and Palo Alto Networks (NASDAQ:PANW) on the grounds of a “meaningfully worse” security environment. That was followed by CrowdStrike reporting its best quarter ever.

By late September, analysts were split on whether stocks had gotten ahead of what companies can deliver.

Bernstein’s Peter Weed downgraded several names, including Palo Alto, Okta (NASDAQ:OKTA) and SentinelOne (NYSE:S), in a September 17 note, writing that “cybersecurity may have gotten over its skis."

Meanwhile, Bank of America's (NYSE:BAC) Tal Liani raised price targets a day later, saying “the market is increasingly pricing in a step-function increase in cyber risk.”

In the weeks since the OpenAI incident, reports of AI agents breaching live networks have multiplied, including the discovery of a nine month breach at the Pentagon that exposed the names, Social Security numbers and military specialties of more than 3 million people.

What's next for defense and cybersecurity?

Heading into the final quarter of 2026, the defense and cybersecurity markets are facing contrasting inflection points as investors weigh policy clarity against valuation discipline.

Midterms key for defense market

Standout Q3 earnings from prime contractors underscore that underlying demand remains robust.

Lockheed Martin and RTX (NYSE:RTX) have validated the bullish camp — Lockheed Martin topped expectations with US$7.97 in adjusted earnings per share, and raised its full-year outlook on surging missile orders. RTX, meanwhile, reported a record US$340 billion backlog in its results for the third quarter.

That fundamental resilience has led several analysts in the sector to view the recent pullback as an attractive entry point. In his September note, Bernstein's Harned rejected fears that potential Democrat gains in the US midterm elections will hurt spending, noting that he expects defense investment budgets to rise in 2027; he also called the November 3 vote a “clearing event and likely a good time to move into these stocks.”

Citigroup's (NYSE:C) John Godyn said in an October note that the sector is near a tactical bottom, echoing Vertical Research’s Robert Stallard, who upgraded Lockheed Martin after arguing that the worst of the fiscal and election noise is already priced in. In early October, Barclays (NYSE:BCS) analyst Anthony Valentini leaned bullish on commercial aerospace and next-generation defense tech, assigning "overweight" ratings to names like Palantir (NASDAQ:PLTR), Boeing and Kratos (NASDAQ:KTOS), but urged caution on traditional defense, citing “more downside risk than upside potential” for US defense spending as political uncertainties and upcoming election cycles loom.

Whether the momentum seen in core defense franchises can broaden across the sector now hinges on Capitol Hill, where the stopgap measure expires in mid-December.

AI worries to drive cybersecurity spending

Heading into 2027, cybersecurity is shifting from a momentum-driven trade fueled by AI safety headlines into a rigorous test of commercial execution. Experts see cybersecurity spending growing as companies adopt AI.

George Varghese, head of investment at Singapore-based AI infrastructure firm 0G Labs, told the Investing News Network that the sector's enthusiasm reflects an irreversible shift in threat economics.

“I believe we’re still underestimating how much AI will impact the cybersecurity market over the next several years. The economics of cyberattacks have changed dramatically. What previously required significant technical expertise, time and resources can now be executed with increasingly sophisticated AI tools at a fraction of the cost. That creates a very real problem for enterprises, and it’s why I expect cybersecurity budgets to continue growing well into 2027," he said.

Citing projections from Gartner that AI-related security spending will climb from US$51.3 billion this year to US$86 billion in 2027, Varghese argued that current multiples reflect a real commercial opportunity.

“From an investment perspective, I see the current enthusiasm as justified by a structural shift in demand, although certain valuations have undoubtedly moved faster than revenues," he added. “What’s particularly exciting is that we’re still in the early stages of securing autonomous AI systems themselves. As companies deploy thousands of AI agents capable of making decisions and executing transactions, the security requirements will expand considerably. I think the companies building for that environment have an enormous commercial opportunity ahead of them.”

Courtney Olujobi, principal at San Francisco-based Moon Pursuit Capital, warned that the market has mistakenly treated every security vendor as an equal beneficiary of this rising tide:

“The demand is real. AI has made attacks faster, cheaper to run and harder to detect. Every company deploying AI internally is also adding systems that can be compromised. Enterprises that can’t absorb a major breach are spending, and that spending isn’t discretionary.

“But share prices have moved as if every vendor captures that demand equally, and they won’t. Buyers are consolidating onto fewer security platforms, so the spending is real, but concentrated. The winners will be the companies that turn demand into recurring revenue and expanding margins. Much of the rest is being priced on the threat narrative rather than on its own numbers.”

Where capital is flowing: Autonomous agents, identity, cryptography

Identity and access management are seen as the most durable recipients of corporate spending, with interest driven directly by the rapid enterprise rollout of autonomous agents.

“The durable spending is going to identity. As companies let AI agents act on their own, every agent becomes a new identity with access to systems and data. Knowing what those agents can reach, what they’re doing and how to shut them down when compromised is becoming a board-level question," Olujobi explained.

"Identity and access management, cloud security, data protection and AI-driven detection are where that money is landing,” she added, also identifying post-quantum cryptography as an underappreciated, non-cyclical growth area.

“Adversaries are already collecting encrypted data with the expectation of decrypting it later," Olujobi continued. "Moving to quantum-resistant encryption is a multi-year project for banks, hospitals and anyone holding long-lived sensitive data. That isn’t a hype cycle. It’s a replacement cycle with a regulatory clock attached.”

From an infrastructure perspective, Varghese noted that securing autonomous systems requires an entirely new layer of cryptographic verification. He commented:

“We’re entering an environment where software can execute financial transactions, access sensitive information and interact with other autonomous systems without constant human supervision. That requires a fundamentally different approach to security. At 0G Labs, we’re particularly focused on the importance of verifiable AI, where organizations can establish which models produced particular outputs and confirm that those outputs haven’t been manipulated.

"I see enormous potential for solutions that combine cryptographic verification, secure computing and transparent audit trails, particularly as AI becomes embedded in financial services and other highly regulated industries. These are long-term infrastructure requirements, and I expect investment in them to accelerate as enterprises move from experimenting with AI agents to deploying them commercially.”

Looking ahead into 2027, both experts see a sharp dispersion between platform leaders and vulnerable point solutions. Olujobi warned that single-product vendors will feel margin squeezes as enterprise buyers pare down vendors:

“As platforms absorb features and AI lowers the cost of building basic tools, single-product vendors without a real edge will get squeezed on price. Spending lasting and every vendor lasting are two different bets. Across emerging technology more broadly, 2027 is when investors start asking for the receipts on AI. Enormous capital has gone into infrastructure, software and security. Now companies have to show those investments are producing commercial returns."

Varghese agreed that the chief downside risk for public equity investors is how rapidly AI itself may commoditize traditional security software: “The biggest risk I see is that investors underestimate how quickly the technology landscape can change. A security product that looks essential today could face intense competition within a year, particularly as major cloud providers integrate similar capabilities into their existing platforms."

He continued, "Valuations also matter, but I’m optimistic about the long-term opportunity because we’re moving towards a world where AI systems will handle increasingly valuable information and transactions, and the infrastructure required to secure and verify those activities will be essential.”

Ultimately, 2027 will see investors stop paying for broad thematic headlines. Winners across both the defense and cybersecurity sectors will be defined by disciplined execution.