In 2005, years before the subprime mortgage crisis kicked off the Great Recession and led millions of Americans to lose their homes, Larry McDonald was a vice president at the infamous now-defunct global financial services firm Lehman Brothers. As a young trader he, along with many of his peers, warned that something was wrong in the real estate market that year. It “was living on borrowed time,” he would explain years later in a 2009 New York Times article, and Lehman Brothers “was headed directly for the biggest subprime iceberg ever seen.”
But McDonald’s bosses ignored his warnings, and the 158-year-old institution that was Lehman eventually went under in 2008 after the housing bubble cracked. The S&P 500 would go on to lose roughly 50% of its value in the 17-month bear market that ended in March 2009.
Now, McDonald, the editor and founder of the widely read investing newsletter The Bear Traps Report, is warning that another stock market crash is on the way. He says the “Lehman systemic risk indicators” that he developed after the subprime mortgage crisis—which include things like the corporate default rate, stock market short-interest ratios, and investor sentiment surveys—are all flashing warning signs.
“[O]ur 21 Lehman systemic risk indicators are pointing at the highest probability of a crash or a sharp drawdown in the next 60 days—the highest probability since COVID,” he told CNBC Tuesday, referencing the COVID-induced market drop of March 2020.
McDonald believes investors are ignoring the risk of a “rolling credit crisis” after the failure of Silicon Valley Bank and Signature Bank as well as the unexpected demise of the Swiss lender Credit Suisse, and focusing too much on the rise of new technologies like artificial intelligence and robotics.
“We saw this before with Lehman, what happens is a shock comes in, credit markets start pricing the risk, but equities don’t. They focus on things like A.I. or things like the dotcom revolution in the ’90s,” he warned, giving a nod to the errors investors made before the dotcom bubble’s blowup sent stocks tumbling in 2001.
McDonald noted that even after the Federal Deposit Insurance Corporation (FDIC) stepped in to save both uninsured and insured depositors at SVB and Signature Bank this month, U.S. banks are still sitting on hundreds of billions of dollars in unrealized losses. The mortgage-backed securities and U.S. Treasuries that make up a majority of many banks’ holdings have seen their value slashed after a series of aggressive Federal Reserve interest rate hikes this past year. These losses have led to significant instability at some banks, forcing many of their peers to tighten lending standards and prepare for potential bank runs.
McDonald said banks’ issues are beginning to spread to the commercial real estate market now as a result of the lending slowdown, and he worries they could infect other sectors of the economy as the Fed raises rates to fight inflation.
The good news is this is “not a Lehman event” that will cause a devastating recession, “it’s just a rolling, slow-moving credit crisis, because the Fed is fighting it behind the scenes,” McDonald said. But that doesn’t mean stocks are safe—a sharp drawdown is on its way, he warned.