January 2022 Outlook — Year of the DAO?
Image by Mufid Majnun
What a wonderful time of year. Gyms are crowded, social media is full of humblebrags, and COVID is under control! Sarcasm aside, in spite of negative news in the media, I hope everyone was able to enjoy the holidays in their own way and that the start of 2022 brought a little extra energy. I spent a good portion of my December researching decentralized autonomous organizations, more commonly referred to as DAOs. I’ll discuss DAOs before recapping markets, highlighting some key events in December, and discussing my updated forecasts.
DAO Overview
Although I first heard of DAOs in the summer of 2021, I didn’t decide to do a deep dive until early December when I saw on Twitter that DAOs had been brought up at a recent congressional hearing on cryptocurrency1. One of the both alluring and dubious aspects that people quickly notice about certain DAOs is their absurdly high interest rate offerings. While the rates vary over time, annual percentage yields in the 100s or even 1000s of percents are not uncommon2. Seeing this, I had to dig deeper.
At the highest level, DAOs aren’t that complicated. Like any centralized organization, DAOs can exist to serve any purpose. Examples of efforts undertaken by DAOs include buying carbon credits, acting as venture capitalists, donating to charity, and collecting rare goods. The main difference between a DAO and a centralized organization is how they are structured. While centralized organizations likely have main partners as well as limited partners and perhaps other investors, DAOs in theory don’t have this hierarchy. DAOs do have developers, leaders, marketing professionals, etc., but these individuals don’t possess as much control as they would in a centralized organization. Smart contracts govern the actions of the DAO; smart contracts are documents built on blockchains that contain rules and procedures for transactions. In the case of a DAO, smart contracts determine how the treasury (the DAO’s assets) is managed – rules exist to determine when to issue tokens to members as well as when to increase the supply or reduce the supply of tokens. These rules are supposed to be made publicly available so that all prospective and existing stakeholders can scrutinize them. The rules can only be altered if a majority of the members of the DAO agree to make changes. Membership requirements vary – some DAOs are fully open while others require token ownership or even NFT ownership (If NFTs, smart contracts, or even cryptocurrencies are foreign terms, I apologize. I won’t define all these terms explicitly here, but I’m happy to share educational resources if requested). The draw of DAOs is that in theory, money can be pooled to undertake efforts that are infeasible for most individuals. Additionally, given the decentralized structure, the risk of the funds being drained by the DAO development team should be lower. As with most blockchain projects, DAOs face the risk of being hacked, and a number of scam projects exist.
The above foundation is by no means a full account of what DAOs are, but it’s enough for me to move on to some of my interpretations of what investing in a DAO entails. Firstly, from what I understand, there are only 2 ways to make money by investing in a DAO:
Invest in a DAO where the assets of the treasury increase, or
Passively acquire greater proportional ownership in the DAO.
The first method is relatively easy to understand; if the DAO one is invested in purchases assets that increase in value over time, the investment will appreciate. Alternatively, if more people invest in the DAO, the size of the treasury will also increase.
The second method is slightly more complicated and to my knowledge is linked specifically to certain DAOs. This method relates to the absurd interest rates some DAOs offer. For ease of computation, I will create the fictional DAO V-Fake DAO that pays 900% APY to those who stake their holdings (as of this writing, no DAO of this name exists, but if one does exist in the future, it is unrelated to this example). One point of clarity to establish is that interest is paid in DAO tokens, not dollars or any other cryptocurrency. The tokens will be defined as V-DAOs. With a 900% interest rate, owning and staking 1 token will lead to owning 10 tokens at the end of a 12-month period (a 100% APY would lead to a payout of 1 token). Finally, for simplicity, I will assume that 100 tokens exist at the start of the investment, all investors purchase their tokens at the same time, and after one year the value of the treasury is the same. If I buy and stake 1 token today, a year from now, I’ll be the proud owner of 10 V-DAOs. However, these tokens generated from the interest rate are “printed” by the treasury – they aren’t collected from someone else. Therefore, if I’m the only investor to stake my tokens, then the overall supply of tokens has increased from 100 to 109, and I own 10 out of 109 instead of 1 out of 100. My proportional ownership has increased in this case. Alternatively, if all the other 99 holders also staked their holdings, 900 total new tokens would have been made, and even though I would now have 10 tokens, the proportion of my ownership would be the same.
In practice, DAOs often pay interest much more frequent than annually, and the percent APY they offer isn’t fixed over long periods. Regarding the math behind those who stake versus those who don’t, I will confess that this is conjecture; I haven’t invested in a DAO and seen that happen. What I can say from observation is that as the supply of tokens issued by a DAO increases, the price of one token tends to fall, reflecting the expected impact of the supply of tokens increasing at a faster rate than the treasury is growing. I’m not invested in any DAOs currently, and at this moment, I haven’t found one I really like. I’m slowing warming up to cryptocurrency, but I stay on exchanges. While some DAOs are listed on major exchanges and can be invested into easily, others are off-exchange and will require fees and greater knowledge of crypto investing than what is required to trade on an exchange. I don’t know what the future holds for DAOs, but a vehicle to bring people with ideas and capital together across borders is compelling. If nothing else, I will do my best to track developments in the space.
Market Recap, Commentary, Outlook
Switching over to markets I’m more familiar with, performance in December was choppy but smoothened out into the holidays. US core fixed income fell 59 basis points; while the recently released minutes from the Federal Reserve meeting showed that the Fed is open to tapering asset purchases and raising interest rates more quickly than expected in order to combat inflation, the actual 10-year yield on US treasuries moved from 1.43% to 1.52%3. A nine basis point move isn’t inconsequential, but it isn’t earth-shattering either. Nonetheless, rising yields correlate with falling fixed income prices, so the rise in yields likely explains part of the decline in fixed income. In the first few days of this year, the 10-year yield has risen quite fast -- I’ll say more after the recap. All return calculations come from historical data on Yahoo Finance9 and are my best attempt to capture price return as well as dividend returns. The US Vanguard Real Estate Index (my proxy for US real estate) rose almost 10% -- new housing starts rose substantially as demand for housing returned; any fears of rising rates were either ignored or overpowered by sheer demand. Internationally, the MSCI EAFE Index rose 4.4%, the MSCI Emerging Markets Index was up about 1.5%, and the Vanguard Global ex-US Real Estate Index rose about 3.2%. A slight drop in the dollar may have been a tailwind for developed markets, especially during the holiday season, but emerging market equities weren’t lifted as heavily. South Africa, one of the larger country weights in the emerging market equity index I follow, was disproportionately affected by the omicron variant of COVID-19. Generally, countries categorized as emerging tend to have lower vaccination rates than developed nations4 (there are of course exceptions to this trend), and a lower rate of vaccination makes the virus more problematic. Global real estate continues to struggle. Moving to US equities, a sharp rotation from growth to value occurred with the S&P 500 Value Index outperforming its growth counterpart by about 4%. Some are saying this is simply mean reversion given that growth has strongly outperformed value for quite some time now5. Interest rate expectations may also have played a role, with higher interest rates historically being more correlated with outperformance of value stocks. One of the difficulties with using expectations in quantitative models is that expectations are often revised, generally to more closely reflect what actually happened. Users of this data in real time don’t have the benefit of the revised data, and the revised data may appear as a more statistically significant predictor than the raw data. Although this is the case, part of my process involves considering new variables should they appear promising. If I find a way to incorporate interest rate expectations into my forecasts in a way that bypasses the issue with revised data, I’ll write about it. Finishing the recap of last month’s market performance, the S&P 500 index rose about 4.6%.
While the end result of performance in December was generally positive, the movement within the month was volatile. At the beginning of the month, the Federal Reserve announced that it may slow purchases of fixed income more quickly than expected and also may raise interest rates earlier than expected. This unsupportive stance shook investor confidence to a degree, but confidence seemed to return by the holidays. Politically, Senator Joe Manchin voted against party lines on President Biden's Build Back Better Act and prevented the bill from being passed6. The Senate is currently approximately evenly split (technically, there are 50 Republicans, 48 Democrats, and 2 independents, but these independents caucus with the Democrats, so for all intents and purpose, the Senate is evenly split7). In the event that a vote is tied, the Vice President is able to break the tie. Manchin voting with Republicans, however, prevented this tiebreaker vote from taking place. Republicans and moderate Democrats, including Manchin, have raised concerns about inflation that would follow if the 2 trillion-dollar stimulus plan was passed6. Some economists argue that the bill would actually ease long-term inflation by increasing productivity and growing the labor force8, but I confess I haven’t read these pieces myself. Assuming the bill would create inflationary pressures, its failing to pass would theoretically have benefitted growth companies using debt to finance their growth; lower inflation leads to lower interest rates which makes debt cheaper to take on. The complicating factor is that some, or even a lot, of the money in the stimulus package may have been intended to go to projects that high-growth companies would have partaken in (e.g. green infrastructure).
The rotation from growth into value has continued into early January – as mentioned previously, the 10-year yield has risen sharply in the first days of the new year. Per the St. Louis Federal Reserve3, while the level of the yield was 1.52% at the end of December, it was 1.73% as of January 6th (approximate date this article was written). It’s almost as though the market was deaf to the Fed’s words about rates until the start of the new year. Rising yields have led to a selloff in growth-oriented equities, and it is yet to be seen if this paradigm shift will persist.
Moving to my updated forecasts, the main changes in my forecasts are with respect to the international asset classes. The dollar weakened slightly in the month of December, and while that has lowered my forecasts for all international asset classes, emerging market equities were hit the hardest. Rising inflation in Europe is also contributing to a lower forecast for international developed markets, but the weaker dollar seems to be the dominant driver behind the reduced expected returns. Within the US, my forecast for the S&P 500 Index rose slightly, and I continue to be overweight growth versus value. This has been a painful trade, and I am reviewing my inputs to see if any improvements can be made. The main challenge is the very high level of inflation that’s being observed. The last time inflation was around these levels was a very brief period in the early 1990s; prior to that, the early to mid-1980s. My models aren’t trained on data from back then, and the market isn’t the same as it was then either. Quantitative models can struggle when the data they face is outside the scope of their training data. Although I rely on my quantitative outputs to make my decisions, the fundamental questions I’m asking are how long inflation will persist at these levels or even increase and where inflation will be once it stabilizes. For the first, I think inflation is here to stay, but I don’t think it will stay at these levels indefinitely. Simply put, the pandemic and subsequent rebound had a distorted effect on GDP growth. It’s hard to say what GDP growth would have been had lockdowns not been so stringent, but in a very short time frame, GDP growth on year-over-year basis was as low as -8.51% annualized and as high as 16.75% annualized.
Year-over-Year % Change in US GDP
Directionally, inflation follows GDP growth but tends to be a lagging variable. The impacts of supply chain disruptions, wage increases, and stimulus are difficult to fully account for, but for the time-being, I think the economy is past its peak with respect to GDP growth. Given its lagging effect, peak inflation may not yet have occurred, but I think it will peak soon before following GDP growth and dropping to a more normal level. Pivoting to the second question, which is what that level will be, I think inflation will be higher than the 2% level the Federal Reserve hopes to target but still in the low single digits. If inflation stabilizes at a higher level than I anticipate (say lower middle to higher middle single digits), I believe this will benefit value stocks. For now, I don’t think this scenario is as likely as the scenario where inflation stabilizes in the low single digits, but if the probabilities of these scenarios change, I’ll have to adjust my expectations. Thanks for reading, and as always, happy investing.
Works Cited
