Former Lehman Brothers trader Larry McDonald, a market veteran who experienced the firm's collapse, is issuing a fresh warning to investors. In a recent interview, the founder of independent research firm "The Bear Traps Report" systematically outlined his view of current markets: a private credit crisis has arrived, an energy shock is creating genuine stagflation, the crowded trade in tech stocks is unwinding, and capital is accelerating its flow into hard assets. This "great migration" into hard assets, he suggests, is only in its second or third inning.
McDonald was direct in his assessment of private credit, calling it "this cycle's subprime." He stated it is unequivocally already a crisis. Through a series of "idea dinners," he has heard increasingly pessimistic views from top credit investors since last year, describing the situation as a "mess" that could lead to imprisonments.
He draws a strong parallel to 2008. Before the subprime crisis, sell-side research frequently used the term "idiosyncratic" to downplay risks. McDonald noted that in the third and fourth quarters of last year, he saw this word used "hundreds of times" in reports explaining bad debts in private credit, suggesting either dishonesty or a complete disconnect from reality.
The structural roots of the problem, according to McDonald, are threefold. First, there are issues with rating agencies, which he compares to scenes from "The Big Short," alleging that small teams are mechanically rating thousands of private credit securities with minimal due diligence. Second, incentive structures are severely distorted. To attract retail money, private credit products promise "quarterly liquidity" to financial advisors for an asset class that is inherently illiquid, offering hefty commissions to keep the game going. Third, a liquidity crisis is already apparent. While private credit funds typically have a 5% quarterly redemption gate, 10%-15% of investors are seeking their money back. He points out that insurance companies, which bought heavily into private credit for yield, are now becoming targets for short sellers like those targeting MetLife.
McDonald believes that once the securitization machine slows, risk will flow back onto bank balance sheets, triggering a full-blown credit crisis. He notes an early sign of trouble: a UBS analyst recently broke from the typical sell-side narrative to warn of large-scale default risks in private credit, indicating a credibility problem on Wall Street. However, he thinks the crisis will be less severe than the subprime meltdown due to scale differences.
Regarding tech stocks, McDonald uses the analogy of "monkeys crowding a tree" to describe their popularity. When shaken, the "weak hands" jump off. Data shows the Nasdaq 100's market capitalization has shrunk from $34 trillion to about $30 trillion, with $4 trillion flowing out. While Microsoft and Nvidia, the S&P 500's two largest components, have fallen approximately 28% and 19% from their highs respectively, the index itself is only down about 6%, indicating a significant rotation out of tech and into sectors like industrials, materials, and energy.
Another pressure on tech stocks is the sharp rise in data center construction costs: diesel prices have increased about 100%, DRAM memory costs are soaring, Caterpillar equipment is in tight supply, and roughly 20% of data centers face location issues (overheating, water scarcity, community opposition), requiring relocation. McDonald argues these factors are compressing profit margin expectations for the "Magnificent 7" tech stocks, and the market is already pricing this in.
McDonald terms the current asset rotation "The Great Migration" and provides historical context. Between 1968 and 1981, the industrial, materials, and energy sectors collectively comprised about 50% of the S&P 500. This ratio recently fell as low as 9% and has now recovered to roughly 13%. He believes it could reach 20%-25%, meaning the migration is still in its early stages. He highlights international resource companies controlling physical assets—like Glencore, BHP, and Freeport-McMoRan—as well as natural gas stocks (particularly "trapped gas" concepts in Canada and Texas) and coal stocks.
On precious metals, McDonald's team sold gold and silver ETFs like GDX and SLV in January but has started buying back during the recent pullback. His rationale is that gold miners have corrected near their 100-day moving average, and household allocations to gold and silver remain around 1.25%, significantly below the roughly 3% seen in the 1980s, indicating they are still severely underweight.
McDonald characterizes the current macro environment as "real stagflation." He argues that Iranian strikes on energy infrastructure in Bahrain, Dubai, and the UAE have disrupted the entire energy supply chain, from fertilizers to jet fuel. Even if Middle East tensions ease, he believes energy price stickiness will persist for at least 5-6 months due to increased insurance costs and logistical disruptions. This energy price surge could drag GDP down by about 1 percentage point. Concurrently, AI-driven layoffs are accelerating—exemplified by Square's 45% staff cut followed by a 30% stock rise—and consumers face an energy "hidden tax," raising recession risks.
This puts the Federal Reserve in a dilemma: sticky inflation prevents rate cuts, but a slowing economy necessitates easing. McDonald expects short-term rates to remain "pinned," leading to a flatter or inverted yield curve, contrary to earlier market bets on steepening. This view played out recently, with several funds betting on curve steepening blowing up last Wednesday and Thursday.
His advice is to buy 2-year or 3-year U.S. Treasuries when their yields approach 4%. The logic: investors can earn 3%-4% risk-free, and if a recession forces the Fed to cut rates aggressively, bond prices would surge, potentially delivering total returns around 8%.
As a major tail risk, McDonald points to the UK, describing a scenario of a weak government, high fiscal deficits, a slowing economy, and energy costs rising faster than in the US. If Britain faces debt financing difficulties and bond vigilantes attack, it could signal similar problems for other high-deficit nations like France and Italy.
For the US dollar, McDonald does not foresee it losing its reserve currency status within 10-15 years, but believes it is on a long-term "secular decline." He cites soaring US debt-to-GDP ratios, now at 120%-125% compared to 70%-80% during the 2008 crisis, and current fiscal deficits around 6%, double the 2%-3% average of the past 50-60 years, as underlying pressures driving the long-term migration from financial assets to hard assets.
Comments