Whatever happened the cannabis stock bubble? What next?

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There is seemingly never a dull day when it comes to cannabis news.

After caffeine and alcohol, cannabis slots in as the third most popular drug in the world. And yet, looking at the stock market, the sector feels infantile in comparison. That is, of course, due to the nebulous legal status of marijuana, which differs greatly around the world.

Even within the US, the difference in legal framework at a federal level and between states means the legality of the drug is all over the shop. Perhaps the below graph displays this better than any.

Chart via disa.com

While the graph shows that many states permit marijuana on at least some capacity, the drug does remain classified as a Schedule 1 controlled substance under the Controlled Substances Act (CSA).

Most notably, this subjects cannabis businesses to the infamous Section 280E. This is a law which prevents traffickers of Schedule I substances, such as cannabis, from deducting “ordinary and necessary” business expenses from their tax bill. In essence, it penalises these companies through the imposition of a higher tax liability based on gross income rather than net income.

Biden is generally seen as more pro-cannabis, however. His election win was a boost for the cannabis industry, given the sector is so heavily dependent on continued regulation and legal status to open up future profits.

I plotted the performance of cannabis stocks against the S&P 500 to show how much of a boom the sector originally saw once Biden won.

Of course, the chart also shows how poorly it has done since. Following an initial surge, with the Marijuana ETF doubling in the three months following the election, it has been torrid ever since. From those peaks, it has pared down a staggering 90%.

Of course, we cannot overestimate the macro situation. This is the reason I plotted it against the S&P 500, in fact. With a whole host of variables coming in hard against the market – the cost of living crisis, interest rate hikes, the Russian war to name a few – sentiment is as bad as it has been since the Great Financial Crash.

But first, why was the rise so great?

The rise

It really is difficult to overstate the impact of the Democrat win in 2020 on cannabis stocks. While it looks hysteric in retrospect, there was reason to this. Like I said above, legality is so vitally important to the industry, and here was an election winner, and party, that represented a very strong proponent of that legality.

This was also during the pandemic boom, when nearly every asset in the world was printing outrageous gains. Biden took office shortly before possibly the peak of it all, when Gamestop and the other meme stocks rocketed upwards off the back of heavy backing by Robinhood retail investors.

Marijuana stocks were a natural candidate for this FOMO-fuelled madness, and that is exactly what happened.

In addition to Biden’s win and the stock trading frenzy, consolidation was flowing through the industry as big players began to merge and acquire, such as Aphria and Tilray, cultivating synergies and boosting margins.

But it wasn’t to last long.

The fall

As the meme craze died off, cannabis stocks began to waver. And then worse – they fell. And quickly.

Perhaps, in looking back, the optimism bred by Biden’s win was too much. While it is undoubtedly a boon, there still remains the fact that should legislation ever pass, it would require converting some Republicans in the Senate. No to mention the fact that Biden would need to sign it, and he has only campaigned on decriminalising it, rather than outright legalising it. He also put into law in his previous life some legislation which increases the sentencing on drug users and dealers.

But let’s be clear here – this was never a fundamental play. Cannabis stocks fit perfectly into the meme stock pandemonium that proved so lucrative in 2021. The only problem is, it’s not 2021 anymore.

This is really a macro tale. The fact remains that cannabis stocks live way out of the risk spectrum. And anything residing in those parts has been absolutely crushed.

The Federal Reserve has pulled the rug of low interest rates, mass money printing and QE bonanza out from under the feet of investors, and assets everywhere have tumbled, as investors fell to safety. In crises, correlations go to 1, and the most high-risk assets tumble the hardest. Cannabis stocks have always been volatile, and were always going to suffer in this environment.

There are other concerns too. Several stocks have been criticised for issuing too many shares. In looking at companies such as Aurora and Sundial Growers, this appears tough to defend. Aurora’s share count has increased over 12,000% between 2014 and the bubble peak in early 2021.

Sundial, on the other hand, did the same. Before Biden took office, the company had half a billion shares outstanding. A few months later, they had tacked on a casual billion more, multiplying the outstanding share count by 3X.

Going forward

Now that the market has cooled off, how do things look going forward? Well, the same old story, really. That means we will be relying on the Federal Reserve for any movements in the stock market, as its fight against inflation wages on.

Marijuana stocks will continue to reverberate, given their place as a high-risk asset. This above all is the key point, meaning any investment would come with great volatility.

It is hard to pick out any one company, given they will all be highly correlated. Perhaps Tilray present the most intriguing, given the average price target of analysts at $4.05 and its (al least relatively) long-standing history within the industry.

But even then, the below chart is…ugly.

Against the above long-term depreciation, what is 15% upside from here? Sure, it feels very achievable, but would a move in the opposite direction be surprising?

The above sort of sums up a lot of what we are seeing in the sector. And anyways, as long as the market keeps bouncing around on the words of the Fed, that will always be the driving factor.

As a whole, it just feels risky to jump into this sector right now. There are too many unknowns here, and coupled with the wider economy facing so much uncertainty, any investment should come with the knowledge that the potential volatility here is extreme – and that includes to the downside, as history shows.

The post Whatever happened the cannabis stock bubble? What next? appeared first on Invezz.

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