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The Fed Blows a Cupcake Bubble

Lessons from the Donut Bubble of '03

By

The number one cupcake play in America is going public.

Crumbs Bake Shop operates 34 cupcake stores from New York to California, humorously billing itself as "creator of the gourmet cupcake."

Owners stand to make up to $100m from the IPO, and the deal could price higher, with cupcake-mania hitting a fever pitch.

At $100m, investors would be paying about $3 million per cupcake store. 

Management is betting on aggressive expansion to fuel growth, and plan to open hundreds of new stores. Naturally, growing a chain of stores from 34 to 300 is no easy task.

Recall the great donut bubble of 2003...

Krispy Kreme (NYSE: KKD) was the darling of Wall Street.

Its shares peaked at near $50 from a split-adjusted IPO price of $3.50, giving the donut maker a sky-high valuation of $3b (pdf). Shares trade around $7 today, up from a low of around $1.

KKD expanded too fast, took on too much debt, and nearly went bankrupt. They also had some accounting issues, but those likely were probably just a side effect of a business-plan gone bad. Today Krispy Kreme is still muddling along, closing stores opened just a few years back.

Expansion is always risky — especially when financed with debt and equity offerings.

Hopefully Crumbs can avoid a similar fate, and follow the glorious path of Chipotle instead, which is up 436% since its IPO in 2006.

In any case, I wish them well; I've heard their cupcakes are delicious.

The larger point here is about what this cupcake IPO says about the state of markets. After all, it almost certainly wouldn't be happening without all that Fed-injected liquidity sloshing around.

Back in July 2008, The Onion published a prescient piece titled, "Recession-Plagued Nation Demands New Bubble to Invest In":

What America needs right now is not more talk and long-term strategy, but a concrete way to create more imaginary wealth in the very immediate future.

Congress is currently considering an emergency economic-stimulus measure, tentatively called the Bubble Act, which would order the Federal Reserve to begin encouraging massive private investment in some fantastical financial scheme in order to get the nation's false economy back on track.

Even Jonathan Swift would have to appreciate satire so pointed.

Unfortunately, the bit reads a lot like a Fed policy statement. Change the title to "Encouraging Risk Investment During Recession," and any good Fed economist would nod along in agreement. The sentiment is identical.

Bernanke has often stated that he wants to create a "wealth effect." Push stocks higher, the theory goes, and people will spend more because they feel richer. Long-term thinking, truly...

It's been two and a half years since the Onion piece was written.

Not only did we get one bubble; we got a handful of them. Notably in commodities, metals, food prices, and treasury bonds.

Malinvestment and moral hazard ride on in 2011

One of the nastier side effects of "easy money" policies is known as malinvestment.

It almost sounds harmless... mal-investment (mal = bad). After all, everybody has a loser every now and then, right?

The problem with easy money is that it inevitably spurs not just bad, but dangerous investments. During the tech bubble, it was countless doomed tech IPOs.

In the most recent crash, low rates fueled the housing bubble. Now we have unaffordably high housing, and 25% of Americans underwater on their mortgages.

Loose money also increases prices for consumers, and endangers the retirement security of millions of Americans through pitifully-low rates on CDS and treasury bonds. To tap it all off, the pithese losses are taxed, to top it all off). Often, they have no choice but to buy much riskier assets. There goes retirement security.

This is all solid economic policy, according to the U.S. Federal Reserve. Until real bank reform is achieved, we will continue to see bubbles in new areas of the market.

Some bubbles are still new, like cupcakes. Others, like treasury bonds, are getting long in the tooth.

Efforts to re-flate existing bubbles will become increasingly desperate over the next few years, as reality sets in and the funding crisis begins in earnest.

Eventually, politicians will do the right thing and reform our broken financial system. Right after they've exhausted every other option.

Adam Sharp
Wealth Daily


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