Kass: Why a 25% Drop Isn't Out of the Question

This blog post originally appeared on RealMoney Silver on Aug. 21 at 7:36 a.m. EDT.

Some loan market participants are now calling last month's losses in the credit market a "Black Swan" event, and I'd go even further by saying it's a sign that stock markets have a long way to go on the downside.

In his book, Nassim Nicholas Taleb describes a Black Swan event as an outlier outcome that is well beyond participants' expectations. It is a rare and highly improbable massive event that is difficult to foresee and terribly important -- for instance, the attacks on 9/11, or any severe stock market crash.

Not only are these Black Swan events generally impossible to predict, but they are also impossible to prevent. The event typically affects participants harshly, but it is readily explained after the fact.

The term Black Swan comes from the ancient Western concept that all swans are white. In that context, a Black Swan was a metaphor for something that could not exist. The 17th century discovery of black swans in Australia transformed the term to connote that the perceived impossibility actually came to pass.

There's lots of Black Swan chatter lately because the S&P/LSTA Leveraged Loan Index took a 3.35% loss last month, representing a "six-sigma move," which is rare for any asset class but especially rare in the historically nonvolatile loan market.

Many, such as Ben Stein, believe that the subprime and lower-credit problems (Black Swan events) are being overstated in terms of their effect on the broader capital markets.

Others, like myself, believe that the subprime experience is symptomatic of the general mispricing of risk and it is being understated in the equity markets -- and that its tail will be long in the credit markets as the pricing of risk undergoes a regression back to the mean.

Who is right?

Time will tell, but it is instructive to go through the exercise of quantifying the significance of the move in lower credit loans in July vs. historic patterns, and then analyze if the recent move lower in equity markets corresponds.