The stock market's next 20 years will be defined by technological innovation — and the most likely scenario is 7% annual growth, DataTrek says

• While the press tends to focus on what stocks will do in the short term, the bigger (and more important) question facing all investors is: "What will US stocks do over the next 20 years?"
• DataTrek co-founder Nicholas Colas said in a note on Friday that the answer to that question will be determined by the pace of technological innovation, as that fuels productivity gains, which boost corporate profits, which drive stock prices.
• Over the next two decades, investors should expect average annual returns of 7% for US stocks, with upside potential dependent on the pace of technological innovation, according to the note.
• Visit Business Insider's homepage for more stories.

While the day-to-day fluctuations of the stock market lead investors and the media to ask what stocks will do in the short term, the bigger and more important question investors should be laser-focused on is: What will US stocks do over the next 20 years?

That's according to DataTrek co-founder Nicholas Colas, who observed in a note on Friday that long-term returns can have a sizable impact on how investors allocate capital, pointing to a surge in venture capital and private equity ownership among endowments and pensions after the S&P 500 posted a negative total return from 2000 to 2009 (the so-called lost decade).

So, going forward, what kind of return can investors expect to receive from the S&P 500 over the next 20 years?

An average annual return of 7%, with upside potential based on the pace of technological innovation, DataTrek said.

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Here's how Colas landed on 7%.

First, investors can "safely" eliminate the prospect of negative returns over the next 20 years because historical returns have never delivered a negative real return over a 20-year time period, according to Colas.

Second, historically high average annual returns of 14% have happened only 22% of the time, and happened during unusual periods when equity valuations start very low (the Great Depression) and include a powerful positive catalyst (post-World War II), explained Colas.

Therefore, investors can settle on a 0% to 14% range of average annual returns for the next 20 years, with a midpoint estimate of 7% the likely result, slightly lower than the often-cited historical average annual return of 10% for stocks, according to DataTrek.

Much of the future returns in the stock market will be dependent on the pace of technological innovation, which drives productivity gains. And an increase in productivity helps boost profits for corporations, which ultimately helps stock prices rise.

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On the flip side, poor demographics going forward point to sub-7% returns, with the US currently treading at sub-1% population growth. The demographic trends look even worse overseas, according to Colas.

The main drivers of historical stock market returns have been interest rates, macroeconomics, geopolitics, and innovation. With interest rates near rock bottom, macro growth likely to be slow, and geopolitics a wildcard, investors will have to rely on tech innovation to drive future returns.

"No wonder Tech is the center of US equity markets just now," Colas said.

The trend of technology stocks outperforming the market will likely not change anytime soon, and it means the tech sector is the only sector worth a structural overweight, he added.

But if the tech industry doesn't drive the innovation needed for stocks to continue to rise in the long run, then "the investment case for equities over the long run diminishes considerably," Colas concluded.

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