Blog - Investing Notes

February 22, 2007 - Does Aggregate Technological Innovation Predict Stock Returns? (Updated 3/1/07)

If there is a surge in innovation in a given year, should we expect a surge in stock prices the next year or the year after? To explore this question, we consider the pace of U.S. utility (invention) patent applications as a very simple measure of innovation. Using the annual number of U.S. utility patent applications and the corresponding annual behavior of the S&P 500 index during 1963-2005 (43 years). We find that:

The following graph compares the behaviors of U.S. utility patent applications and the S&P 500 index over the sample period. It shows that both tend to increase at an increasing rate; their advances compound over time. Visual inspection hints that patent activity may lag, rather than lead, stock market behavior.

For a more precise test of the relationship, we relate changes in the variables via a scatter plot.

Based on a guess that innovation might lead stock market valuation by a couple of years, the following scatter plot relates annual change in the S&P 500 index to annual change in U.S. utility patent applications two years prior. While the best-fit line has a positive slope, the plot is very dispersed. The Pearson correlation is just 0.08 (with R-squared just 0.01). There is apparently no relationship between these two series.

Next we check to see whether some other lead-lag interval might support prediction.

The final chart explores the lead-lag relationship between annual change in the S&P 500 index and annual change in U.S. utility patent applications over the sample period. Although none of the correlations are impressive, the chart suggests that:

Stock market behavior is a weak positive indicator for future patent activity, perhaps by affecting the amount of capital available to invest in innovation. A strong (weak) stock market makes it easy (hard) for research organizations to raise funds.

Patent activity is not an indicator of future stock returns. A possible interpretation of this result is that the interval between patent application and market realization of the associated innovation has random (unpredictable) length.

In summary, stock market returns positively but weakly predict changes in the level of future innovation, but changes in the level of innovation do not predict stock returns.

Said differently, greater luxury to research begets incremental innovation, with the benefits of innovation spread randomly across future years.

For related research, see Blog Synthesis: Valuation Based on Fundamentals.

Reader Marv Watkins offers an alternative explanation for the lag in patent applications, as follows:

Current organizational patenting behavior is primarily defensive. Companies increasingly patent trivial and obvious inventions for the purpose of amassing large patent portfolios to defend themselves against other companies with patents. And increasingly, patent trolls are acquiring patents for the sole purpose of suing (mostly small) companies for patent infringement.

Here is a quote from Innovation and Its Discontents by Adam Jaffe and Josh Lerner:

"In the last two decades, however, the role of patents in the U.S. innovation system has changed from fuel for the engine to sand in the gears. Two apparently mundane changes in patent law and policy have subtly but inexorably transformed the patent system from a shield that innovators could use to protect themselves, to a grenade that firms lob indiscriminately at their competitors, thereby increasing the cost and risk of innovation rather than decreasing it."

So, the reason that patents *follow* the market is that companies that develop successful business opportunities fabricate patents for the purpose of using lawsuits to prevent competition.

There are a wealth of related resources on Groklaw's section on patents.