April 1 (Reuters) - U.S. defense stocks have declined even as the Iran war drags on, indicating that the typical "buy-on-conflict" trade had largely peaked in the weeks before in anticipation of tougher action by President Donald Trump.

The NYSE Arca Defense index, which includes 34 small and large-cap U.S. companies, fell nearly 8% in March, compared with the broader S&P 500's 5% drop. In contrast, it had gained about 12% in February 2022, when Russia invaded Ukraine.

The sluggish performance, strategists said, signaled investors were unwinding positions after a strong run this year and does not reflect fading demand or doubts about longer-term defense spending.

"A lot of conflict premium was in their valuations," said David Bianco, Americas chief investment officer at German asset manager DWS.

"We saw gold and oil and defense rally, part of the reason was messages from the administration, when Trump was sending the armada to the Middle East. Nobody knew anything, but they saw chances of a conflict."

Bianco said he began reducing his "overweight" position on defense stocks before the Middle East conflict began.

There were signs well before the U.S.-Israeli bombing began in late February that Washington was preparing for a confrontation with Tehran.

Reuters reported in the weeks leading up to the war that the U.S. was building up forces in the Middle East and preparing for a weeks-long operation if diplomacy failed.

Similarly, the European defense sector fell 11% in March, marking its biggest monthly loss since the pandemic amid a broad selloff on worries of a potential energy shock due to the war. Defense shares had rallied for weeks as European governments announced sweeping rearmament plans following Russia's invasion of Ukraine.

Earlier this year, Trump proposed a $1.5 trillion U.S. military budget for 2027, well above the $901 billion approved for 2026, but uncertainty remains over whether Congress will pass 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 said in a recent note.

The defense index has surged more than 150% between 2020 and 2025, leaving the sector at historically elevated valuations.

The S&P 500 Aerospace & Defense sub-index trades at about 32 times 12-month forward earnings, well above the broader S&P 500's multiple of roughly 20 times, according to LSEG data.

EARNINGS EXPECTATIONS MUTED DESPITE WAR

Market reaction has also been subdued to the Pentagon's attempts to boost production to replenish depleted missile and ammunition stockpiles.

Any revenue gains will take time to materialize as long production cycles and capacity constraints limit how quickly output can ramp up, analysts say.

Expectations for 2026 earnings growth hovered around 12% at the end of March versus about 15% at the start of 2026 for General Dynamics, Lockheed Martin, Northrop Grumman, L3Harris and RTX, according to Tajinder Dhillon, head of earnings and equity research at LSEG Data & Analytics.

"The conflict would need to last longer, or expand materially, for (earnings) estimates to move higher," said Sameer Samana, head of global equities at Wells Fargo Investment Institute.

SUPPLY CONSTRAINTS, POLICY PRESSURE

Beyond valuations, investors pointed to limited production flexibility.

Richard Safran, senior analyst and managing director of aerospace and defense at Seaport Research Partners, said funding of defense firms gets diverted to immediate operational needs rather than modernization or development needs during conflicts.

The Trump administration is also pressuring defense firms to prioritize production over shareholder payouts, exacerbating uncertainty around capital returns.

The sector's medium-term outlook depends heavily on U.S. budget decisions, with key spending details expected on April 21, Bloomberg News reported.

(Reporting by Purvi Agarwal, Rashika Singh, Avinash P and Johann Cherian in Bengaluru; writing by Medha Singh; Editing by Sriraj Kalluvila)