Bubble Logic

-This picture was taken in Bentonville last week, and it's not the only cupcake store in NorthWest Arkansas, do I smell a tasty & delicious bubble? Also, sorry for the random co-worker who stepped in front of my phone.

My dear readers, it’s finally occurring, the long brownies/short cupcakes arbitrage strategy is finally paying off! I quote a headline from a recent article on Yahoo!’s homepage: “Cupcakes and 6 Other Food Trends That Have Lost Their Cool”

I don’t like to brag or anything, but I think I could be the John Paulson of the dessert market. And, if this comparison proves to be true, I would really like to have a book written about this mythical trade entitled “The Tastiest Trade Ever”, you may remember Mr. Paulson had a book written about his short of the housing market in 2008 called “The Greatest Trade Ever”.

To explain how to make a killing in the dessert market without spending a single grain of sugar from your sugar reserves you must have an understanding of a couple key terms, we’ll start with arbitrage. Arbitrage is a wonderful idea, but typically only occurs in theory and the world of super-computing, the latter I don’t’ have access to and the former doesn’t exist so none of the following writing is applicable to much of anything in my world or likely yours, but I digress. What I was about to get to is that arbitrage is all about mis-pricing, this can be the mis-pricing of a single asset traded in two different markets or the divergence (a statistical anomaly) of one or more assets from an expected or observed, price or pricing relationship. This statistical divergence lends itself to the particular kind of arbitrage set up in the long brownies/short cupcake strategy, statistical arbitrage (statarb for short, try using statarb in a sentence today, people will think you know more than you do).

I have long been an observer/partaker in the dessert market, and have participated in many of the ups and downs of this market. I was a participating member in the 2004 Great Vanilla Ice Cream Intake bubble and sadly I was also present for the subsequent sugar crash that always follows those kinds of gluttonous bubbles. Dessert cakes have long been a favorite sector but until recently I hadn’t noticed the trade to make it profitable. The dessert cake sector of this market is highlighted by a small, but tasty, set of securities ranging from the aforementioned cupcakes and brownies to such luminaries as lemon bars, cookie cakes, tiramisu, and coffee cake. An interesting thing is that while all members of this sector compete against one another, their prices are highly positively correlated, or at least I think they could be. When cupcakes began outpacing the others after much publicity in the Sex and the City TV series and subsequent movies I began to take notice. Not wanting to expose myself to potential upside still in the cupcake bubble I looked to statarb to remove the risk. To illustrate this risk reduction, imagine I short cupcakes at a $2X/unit and buy an equal dollar amount of brownies at $X/unit. Knowing, from prior research, brownies trade at parity with cupcakes (unlike pricy tiramisu) I can go long brownies and short cupcakes as I believe brownies are undervalued relative to cupcakes and when the prices converge, in percentage and not actual price, I make money.

As I see it, the beauty of this trade is two-fold, 1) I don’t have to know anything about the current price of the items, or even where the prices are going, essentially I am betting the percent spread between cupcakes and brownies will tighten in the future, and 2) I can fund the purchase of brownies by the short of cupcakes, thus limiting, or even reducing altogether, my capital outlay. Another benefit (although one I don’t subscribe to) is, theoretically at least, this is a risk-free trade.

So to wrap this all up I’ll conclude with this profound statement, I’ve just profited from a trade in which I didn’t have to spend a dime and didn’t take on any risk, sounds enticing, doesn’t it? Also, and as promised, the new poll should be up, the czar (fellow MBA’er here at Walton) thinks Citigroup common stock is headed to $8 within the next year, it currently trades around $4. I think he’s wrong, where do you think it’ll end up in two weeks? I’m going with $3.85, apparently I’m short Citigroup. I’ve had enough blogging for one night, I’m off to O’Hara’s house to hone my statistical skills playing poker (thanks Prof. Aloysius!!).