With the market soaring to two-year highs, is it time to play offense or defense?  Only hindsight will tell for sure. However, one thing is obvious right now:  The crowd is playing offense.

As the prognosis for a stronger recovery has increased, investors have been gravitating toward more aggressive sectors of the stock market.  But I’m not sold. My instincts tell me that when the crowd is playing offense, it’s a good time to start playing defense.

For example, the market’s top performing sectors for 2010 included cyclical industries such as technology, industrial materials and consumer products. In fact, these cyclical sectors have been among the market’s best performing since the market’s bottom in March of 2009. Can this nearly two-year run continue?

On the other hand, defensive industries (those with earnings less dependent on the economy) have been laggards in the market recovery.  For example, the utilities, health care, and defense sectors have been among the worst-performing market sectors for the past two years. I think these sectors may be due for a reversal of fortune — I’m particularly interested in the defense industry.

After outperforming the market for most of the last decade, Morningstar’s Aerospace and Defense industry category has underperformed the S&P 500 for the last two years. But that could change soon…

Not only is the defense sector a defensive industry in this go-go market, but investors have feared that the current debt and deficit fiasco will lead to severe cuts in the defense budget. In addition, the war in Iraq is winding down and the Obama administration seems determined to bring fighting in Afghanistan to an end as soon as possible. All this threatens to bring down the demand for new weapons systems and other initiatives, thus reducing revenue for defense contractors.

In fact, the axe is already coming down on the defense budget. Just last week, Defense Secretary Robert Gates announced $78 billion in defense spending cuts during the next five years to go along with the $100 million in cuts already planned.  However, the cuts were less than expected. 

The market may well have overblown the negative effect of likely austerity measures on defense contractors. For one thing, this is still a dangerous world: the constant threat of terrorism looms, and tensions are rising in North Korea and the Middle East.  Also, the defense industry provides a huge number of jobs, which the government will be reluctant to see cut.

So I set out to find the most defensive stock in the defense industry. And I’m pretty confident I’ve found it. In fact, this company is the single largest private recipient of U.S. tax dollars. It was handed an estimated $36 billion from Uncle Sam in 2009 — about $260 from every single household in the United States.

The company I’m talking about is Lockheed Martin (NYSE: LMT), the world’s largest defense contractor.

Lockheed’s stock currently sells at just over 10 times estimated 2010 earnings, compared to an industry average of about 12.4. Lockheed’s valuation is one of its lowest in the past 10 years and represents an incredible opportunity to scoop up a solid, defensive name at a recent price. The stock is nearly 40% below its pre-financial crisis high of about $116.  It also pays an industry high dividend yield of more than 4%.

The company operates in four divisions; Aeronautics (combat aircraft and logistics), Electronic Systems (air and missile defense systems), Information Systems and Global Solutions (air traffic and battle field communications systems) and Space Systems (satellites and ballistic missiles).

While some weapons systems will be scaled back, a huge part of Lockheed’s revenue is generated by maintaining old weapons systems, which should continue in any administration. And while the U.S. government accounted for 85% of sales in 2009, Lockheed’s international sales are strongly increasing.

Consensus analyst estimates call for Lockheed to grow earnings by an average of more than 10% a year for the next five years. This is quite believable, considering the company has grown earnings per share from just $1.05 in 2000 to $7.78 in 2009. And during this time, Lockheed has grown its dividend by an average of 20% a year during the same period.

The company is cash rich — $2.5 billion in free cash flow easily covered $690 million paid out in dividends in the first nine months of 2010.  Lockheed has announced that extra cash will be used to buy back $3 billion worth of shares (about 12% of the total outstanding), which will not only increase shareholder value but is also a vote of confidence by management in the future performance of the stock.

Action to Take –> Lockheed is currently an undervalued stock with a high (and growing) dividend yield and solid earnings prospects going forward. The stock is a good pick for investors wanting a safe income-generating bet in an uncertain market.