As the calendar turns to 2018 we must admit to occasionally straying from our normal analysis of management teams, financial statements and stock valuations. It is easy to find ourselves dissecting whether our local football team can go on the road and beat Philly and whether a potential home game in the Super Bowl is really just a cruel set up for the ultimate “punch to the gut” of a long suffering fan base.

Football analysis aside, we thought it would be a good time to write about the age old question of stock market prospects relative to bonds. We would offer the caveat up front that we are not financial planners, but we are students of the equity markets, including factors that can influence the broader trend for the equity market. Individual investors should consider their own financial situation and goals and consult with a financial planner in determining the proper allocation to stocks, bonds or any other asset class. However, in terms of the attractiveness of bonds relative to stocks we tend to think that at least for 2018 the backdrop appears to favor investing in the stock market.

Bond Yields Remain at Historic Lows
For context, 10-Year U.S. Treasury rates have remained in the 2-2.5% range throughout the past two years and the highest quality 10-Year Corporate Bonds offer yields that remain near historic lows based on U.S. Treasury data shown below. Bond yields are predicted to move higher over time. At some point, higher yielding bonds could be attractive enough to pose a risk of capital flowing out of equities. However, in our view we have not reached a point in time where that is the case.

High Quality Corporate Bond Yields

Relative to Bonds, Stocks to Benefit More From Tax Reform
As we highlighted in our July newsletter, U.S. tax reform provides a significant benefit for many U.S. based publicly traded companies and a catalyst for stocks to continue to appreciate. The tax cuts should fuel increased future earnings making stocks less expensive. The tax cuts also bolster U.S. corporate balance sheets, which could help fund acquisitions and increase dividends. A case could be made that declining corporate taxes potentially have a negative effect on the Federal Government’s balance sheet, which back U.S. Treasury Bonds. The prospect of investing in U.S. Treasuries with the potential for inflation and lower U.S. corporate tax receipts in the future seems far less attractive to us than prospects for the stock market. While corporate bonds may be backed by companies that have more financial strength thanks to relaxed corporate tax rates, their fixed interest coupons over a holding period offer limited returns for investors.

Favorable Backdrop for Small and Large-Cap Stocks in 2018
Our traditional focus has long been on small-cap stocks with uncommon innovation that leads to potential for significant growth and stock appreciation. We still see plenty of companies that fit that description with many larger companies as potential acquirers with more capital at their disposal. Over the past several years we have also refined our approach to our large-cap stock investment strategy to better capitalize on opportunities in that area of the market. We are encouraged about the early results in 2018 and see good prospects in the years ahead driven by U.S. based large-cap portfolio holdings that benefit from increased earnings and cash flow from reduced taxes. Many of our holdings also provide significant dividends that approach the yields of many of the high quality bonds depicted in the treasury data on the prior page. In our view, these types of “blue chip” stocks have prospects to perform significantly better than corporate bonds in 2018.

—Dan Garofalo & Adam Engebretson
Senior Portfolio Managers
January 2018

Kopp Investment Advisors 8400 Normandale Lake Boulevard Suite 1450 Bloomington, MN 55437 Tel: 952.841.0400 / 800.333.9128