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

A little-discussed loan index recorded a 'six-sigma' move. What if stocks follow suit?
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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.

The S&P/LSTA Leveraged Loan Index was established 10 years ago. Its monthly return over the 127 months has averaged 0.42%, with a standard deviation of 0.63%. So July's loss of 3.35% was over six standard deviations from the average. The largest monthly move prior to July was a loss of 1.51% in September 2001; this was 3.6 standard deviations from the average return.

Let's put the Loan Index's move into an equity perspective over the same 10.5 years and calculate what a six-sigma event would mean for equities.

Since 1997, equities have produced an average monthly return of 0.79%, with a standard deviation of 4.36%. There has never been a six-sigma event in that time frame. The largest monthly price change was a 14.5% loss in August 1998 (during Long Term Capital Management's demise); this represented over 4 standard deviations from average returns.

So, using historic equity returns, the stock market would have to be

down by about 25.4% in order to have a comparable six-sigma event

to the one that the Loan Index recorded in July 2007.

According to Yale University's

Robert Shiller

, there have only been two six-sigma monthly drops in the equity market in the past century. In November 1929, stocks dropped 26.5%, or 7.8 standard deviations away from the average, and in April 1932, stocks fell by 24%, or 6.4 standard deviations. In recent years, the largest monthly loss came in November 1987, when equities had a 12.5% swoon, representing 3.07 standard deviations from the average.

I am not saying that the recent six-sigma event in the Loan Index must necessarily translate into a six-sigma event in equities. Rather, the purpose of today's opening missive is to put the Loan Index's drubbing into an equity context.

What I do know is that the

S&P 500

is only about 6% or 7% lower than the six-year high achieved in mid-July. My personal view remains the same: I do not believe that the equity markets' decline is anywhere near over, and I do believe that the recent dip has not incorporated the full impact of the deteriorating credit cycle.

I suspect, in the fullness of time, a cumulative decline of 20%-25% would not be surprising.

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At time of publication, Kass and/or his funds held no positions in the stocks mentioned, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd. Until 1996, he was senior portfolio manager at Omega Advisors, a $6 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box."