A good question is whether the CEF market behavior of the last few weeks can be described as capitulation. Capitulation can be a useful market dynamic to gauge because it creates an asymmetrically positive flow picture. During capitulation weak hands get out of the market which, in turn, causes less selling pressure going forward. Some of the signs of CEF capitulation in our view would be:
- Similar price moves across sectors without regard to quality,
- large absolute drawdown
- big moves wider in discounts,
- unusually high volume,
- increased CEF beta to major assets such as stocks or Treasuries, and
- non-linear behavior in CEF returns.
Let’s look at these in turn.
One sign of capitulation would be a baby with the bathwater dynamic – if we saw higher-quality sectors like Munis or Agencies experience similar discount moves as lower-quality sectors like High-Yield Bonds or Loans. Evidence here is mixed – Muni sector discount moves have not been excessive and the Agency sector widening is about average. On the other hand the Investment-Grade CEF sector discount move is very large while the EM Debt sector discount move is not that large – mixed signals at best.
Two, taking a look at the rolling 1-year drawdown in the CEF index shows that it is now the third largest this century only behind the COVID and the GFC drawdowns. That said, we need to be careful here since, as we have highlighted repeatedly in late 2021, the CEF market was also unusually expensive. This means that the drawdown size is arguably less relevant than it looks – like a 50%-off item of clothing that was marked up 20% prior to the sale.
Three, fixed-income sector discounts (orange line) are now pretty wide historically though not in the double-digit number area that we have seen during the GFC, the Energy crash, the 2018 market tantrum or the COVID drawdown. Equity sector discounts remain at middling levels.
Four, CEF volumes are elevated but nowhere near the late 2018 or GFC levels.
Five, CEF beta to stocks is at fairly average levels over the past 5 years.
Sixth, CEF price behavior does appear to have accelerated to the downside recently with fewer and smaller dead cat bounces.
Overall, the evidence is mixed – some metrics are pointing towards capitulation but most are not. That said, whether this is capitulation, while an interesting question, may not be the right one to ask.
First, because capitulation is only really knowable after the fact. Two, even a high probability of capitulation doesn’t mean asset prices cannot fall further. And three, because capitulation may just never arrive with markets either stabilizing or continuing to move lower at a slower pace.
In our view, valuations are about as attractive as they have been outside of truly historic market shocks such as the GFC or the COVID period. The question for investors is whether we are going to see a shock of similar magnitude or whether our own base case of a macro muddle-through with a shallow recession is more likely. Investors with a former view may want to remain on the sidelines while those in our camp may want to start nibbling.
Thanks for reading.
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