In Washington, there’s persistent buzz that America has all but set plans to wipe out Iran’s nuclear capabilities this year if diplomacy fails.

That’s just one of the reasons why some Wall Streeters feel defense stocks – up an average 14% in each of the past two years – should be on the offensive this year and act as an effective weapon in bucking a schizophrenic market.

Other factors include such geopolitical worries as the war in Iraq, the mounting hostilities in Afghanistan, the nuclear concerns centering on North Korea and the rapidly deteriorating relationship with Russia.

Integral, as well, to the case for the defense sector are the current costs for fighting the Iraq war: According to the Pentagon, they are running at $6.8 billion a month, or about $80 billion annually, up slightly from a year ago.

The Street reacted favorably to President Bush’s proposed $439.3 billion fiscal 2007 defense budget that goes into effect October 1. The budget is an increase of about 7% versus the enacted $466.6 billion budget for fiscal 2006, which included about $56 billion in supplemental funding to fight the war on terror.

An analyst at Morgan Stanley who tracks the defense sector, Heidi Wood, finds the implications of the budget request intriguing in that the numbers strongly support her view that defense budget growth will remain in force. Likewise, she points out, despite the strong domestic headwinds against higher defense spending, there was only a modest $6 billion differential from what the president proposed in this year’s budget and the estimated $445 billion in last year’s six-year plan.

The implications, she says, are clear: Expect the budgets for Mr. Bush’s remaining defense years ($464.4 billion in fiscal 2008 and $484 billion in fiscal 2009) to vary within a smaller band of predictability than in the past. If that proves to be the case, she says, then there’s a reasonable argument to make for expecting an extension of the defense budget cycle upturn – in other words, defense spending will plateau as opposed to peaking, which she believes has positive valuation implications for defense stocks.

The defense analyst at Jefferies & Company, Howard Rubel, also takes a constructive view of the proposed defense expenditures, which indicate to him that most programs have received adequate funding and that any major pressures (in defense spending) appear to have been pushed off to the fiscal 2008 period. As a result, he concludes that defense-oriented suppliers should go on benefiting in the short run from robust defense budgets.

What’s the best way to play defense? Mr. Rubel thinks the program with the greatest upside is missile defense, which is slated to receive $1.6 billion more in funding. It is spread across a number of line items, including ground based missile defense, which includes such Jefferies buy-rated stocks as Boeing, Orbital Sciences Corporation, and Alliant Techsystems. These stocks are pegged by Mr. Rubel to generate total returns (price appreciation plus yield) of 10% or more over the next 12 months.

Citing growing international turmoil, Fred Dickson, the chief investment strategist of D.A. Davidson & Company, a regional Pacific Northwestern brokerage firm headquartered in Great Falls, Mont., believes shares of defense contractors belong in every investor’s portfolio. Among the names he finds suitable are Lockheed Martin, Boeing, Raytheon, General Dynamics, Halliburton, United Technologies, L-3 Communications, and Computer Sciences. He reckons these stocks could produce gains of about 15% over the next 12 months.

A note of caution about defense budgets: What the president proposes, Congress can take away.

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Slowdown warning: Wall Street’s notoriously optimistic earnings estimates could pose an especially high risk this year, given the widely anticipated economic slowdown in the second half. Accordingly, it behooves investors to be cognizant of companies that could run afoul of slowing earnings growth.

In this context, Dow Theory Forecasts, a well-regarded monthly newsletter out of Hammond, Ind., has just alerted its subscribers to eight companies, including some prominent corporate names, whose pershare profits are projected to grow at a lower rate over the next two years than over the last one- and three-year periods. They are Accenture, Coventry Health, Home Depot, Ingersoll-Rand, Johnson & Johnson, Merrill Lynch, MetLife, and Nike.

Some of the companies in this group are at or near their 10-year highs in net margins, and the newsletter cautions that setting new highs in net margins could prove difficult.