Cannabis Stocks are a Gateway Drug to Losses (For Now Anyway)

By TradeSmith Research Team

Cannabis investors have a message for Joe Biden: The 1990s called, they want their worldview back.

Biden, a U.S. presidential candidate and front runner among Democrats, hurt pot stocks this week by expressing the view that marijuana is a “gateway drug” and shouldn’t be legalized for that reason.

The irritated response from cannabis investors and marijuana enthusiasts — and even from a handful of politicians on both sides of the aisle — was to point out that the “gateway drug” marijuana theory is a relic of the 20th century, is not validated by science, and perhaps should be left in the past where it belongs.

Either way, cannabis stocks took a hit on Monday (no pun intended) after Biden’s view was made public.

But that was far from the only bad news for cannabis stocks, otherwise known as marijuana stocks or pot stocks. The entire industry seemed to peak more than six months ago, in April 2019. Since then, cannabis stocks have been reeling.

Canopy Growth Corp., the largest cannabis stock by market cap, added to the pain with a horrible earnings report last week. The numbers were worse than the lowest analyst estimate, which is actually impressive in a reverse kind of way — Canopy aimed for the floor and missed.

At its peak valuation point circa end-of-April 2019, Canopy Growth Corp. (CGC) was worth more than $18 billion USD. As of this writing, the market cap is just above $5 billion USD — a haircut of more than 70%.

Nor is it just Canopy. The Alternative Harvest cannabis stocks ETF (MJ) is down about 45% over the past 12 months. MedMen Enterprises, another Canadian player, is down more than 80% and laying off staff to survive.

Why are cannabis stocks experiencing such a bloodbath? In four words: Investors got too excited.

They took the budding story (again no pun intended, sorry) of the marijuana industry — which is a genuinely good story — and turned it into a fairy tale of gushing profits with no roadblocks in sight.

The sheer degree of optimism that had been baked into cannabis stocks by mid-2019 suggested that investors must have been, well, high on their own supply (no apologies, couldn’t resist that one).    

This is how it always works — or if not always, then most of the time. It is human nature to take a good story, layer way too much enthusiasm on top of it, and then reap the fruits of bitter disappointment after prices get out of hand.

The good news is that, if you understand how human psychology works, and you are willing to pay attention to charts and trends, you can profit three separate times in a boom and bust sequence: First on the way up, second on the way down, and third on the way back up again.

Take Canopy (CGC) as an example. As with other cannabis stocks, Canopy saw huge enthusiasm in the three-year window between mid-2016 and mid-2019. But as of mid-2019, Canopy had broken a multi-year trendline as the chart  below shows. That demonstrates an opportunity to get neutral if not bearish — especially with the understanding that hyper-enthusiastic booms almost always end in tears.

Canopy had broken a multi-year trendline

Once the hype started wearing off, the potential existed to go bearish on cannabis stocks, possibly by shorting the ETF or buying puts. That is a still a play that could be yielding juicy profits at the moment, as earnings numbers come in horrible and investors flee in horror.

And yet, cannabis stocks are likely to rise again at some point. Why? Because investor pessimism is likely to become just as overdone on the downside as optimism once was on the upside. And also because all the post-Boomer generations — Generation X, Millennials, and Gen Z  — have a far more relaxed attitude toward cannabis than, say, Joe Biden does.

If we keep cannabis stocks on our radar screen, and note the point at which cannabis stocks are left for dead, there could be a future opportunity to go long again from highly compressed valuations. And when should we pull the trigger on that opportunity? The charts will let us know.

TradeSmith Research Team