Dead Count Bounce Is Over, And Canadian Marijuana Index Technicals Look Ugly

Well, it was fun while it lasted. Canadian marijuana stocks (as measured by the Canadian Marijuana Index) have been crushed recently, giving back rebound gains from the recent short volatility rout which saw U.S. equities briefly enter correction territory. While the broad market has retraced 2/3’s of the loss—and Bitcoin even more—cannabis stocks are re-testing recent lows. We explore what happens next.

Before interdicting my own thoughts, we should give plenty of consideration to the words of the man who’s nailed the state of the market lately: Midas Letter CEO and master small cap pundit, Mr. James West.

It was only two months ago that Mr. West warned investors of an imminent valuation bubble is marijuana stocks. In a piece titled Warning Signs Flashing for Downward Valuation of Canadian Cannabis Stocks, James noted, “Overall, I think the valuation picture in Canadian cannabis pubcos could be maxed out, in the case of the largest ones.” Canadian marijuana stocks crested nine days later and corrected 25 percent, peak-to-trough.

And more recently, James West again chimed-in with additional prescient words for investors. Regarding the state of cannabis company valuations, his inference was to the downside: “And do you think they [institutional shareholders] want to refinance these sudden unicorns at top valuations? Hell no. They would much rather the stocks correct on profit-taking selloffs, which, with the trigger of stop loss programming and the increased number of short sellers that such volatility attracts, accelerates and exacerbates the selloff.”

Almost to the letter, that’s exactly what has happened recently.

In our opinion, concerns about frothy valuations is undoubtedly driving the market lower. We pointed out why in a February 14 piece titled Canadian Cannabis Shakeout Giving Investors A Third Investing Lifeline. When basic valuation comparisons were looked at, there was no question the frothiness was getting extreme:

Let’s face it: the bubble was in serious need of a short-term pin. At a valuation apex of about $31 billion (as judged by the Canadian Marijuana Index), Big Cannabis was worth more than Telus Corporation (TSX:TO), a cashflow generating behemoth with $13 billion is annual revenues, $5 billion in annual profits, and 7-10% semi-annual dividend increases through the end of 2019.

So now that we’ve established the market had priced-in the Goldilox scenario, what happens next? Should investor bail, or is the market providing one more great buying opportunity leading up to legalization in late summer?

What The Charts Are Saying

Cannabis stock bulls may want to skip this section. There’s no way to sugarcoat the extreme ugliness of sector price action. As of this writing, the Canadian Marijuana Index has pierced the February 2nd closing & trading lows in convincing fashion. It’s now trading at 625.37, down another 7.42% on the day. Yikes.

Given that the sector is firmly embroiled in capitulation mode right now, standing in front of the freight train isn’t advisable. Especially when you consider weed stocks have uncoupled themselves from “risk on” buying appetites following the early-February volatility washout. The fact that cannabis is crumbling while risk assets party away paints a very foreboding tale of sector sentiment right now. Falling knives and still-expensive markets do not make good bed fellows.

With all that said, I don’t believe you should give up on the sector either. There’s still plenty of latent optimism surrounding the sector’s potential and Canada’s leadership position in the world market. As valuations decline, select cannabis assets become more attractive. And trust me, the bigger fish are very willing to make the right deal.

The fact that the market is expensive isn’t necessarily a mitigating investment factor either. So are various digital retail stocks (i.e. Amazon.com-130 P/E), Netflix, Bitcoin, fine art, and so much more.

While cannabis stock expensiveness is well known, it’s also well-telegraphed. Just like the NASDAQ bubble of the late 1990’s, prices can expand indefinitely after all logical reason is cast aside. Especially true when an important anticipatory catalyst like legalization is waiting to make history just a few short months away.

If you purchased cannabis stocks at elevated price points, we sincerely hope you sidestepped the carnage. If you held tight, there’s probably not much point in selling right now. But for those with capital to put to work, you are entering the sweet spot of what could become a very nice swing trade opportunity.

Here’s what I’m looking for.

Follow The Leader

In Canada, the cannabis sector has a clear and undisputed leader. It was the face of Canadian cannabis before the hype translated into performance in 2016, and it convincingly maintains bellweather status today. With a market cap that’s almost 3-times higher than its nearest competitor, Canopy Growth Corporation (TSE:WEED) is the ultimate sentiment indicator. As goes Canopy Growth, so goes the sector. Obviously, that needle has been pointing down lately.

But the real line in the sand, in my opinion, is coming up shortly. The battle lines will be drawn in the upcoming re-test of the 100-day EMA, which marked the end of Canopy’s 50-percent stock price drop from January 18-February 5. Not coincidentally, this marked the rough timeline where the cannabis sector took a nosedive also (although the January 24 Aurora-CanniMed merger provided a temporary respite).

Canopy Growth hasn’t traded below it’s 100-day EMA since July 2017. At the time, WEED entered a protracted sell-the-news period following Canada’s announcement that Trudeau planned on legalizing marijuana by Canada Day. With the sector’s overarching catalyst in the rear view mirror, predictably, buyers stepped away from the bid.

But this recent selloff is different. Selling has been considerably more vicious and indiscriminate. Details of the legalization timeline are known by all, and we’re in the home-stretch of an expected cannabis sector consolidation period. Valuations are higher as well, and that always leads to more harrowing drops when sentiment turns.

What comes next at the 100-day EMA will probably tell the tale going into the summer. If that inflection point holds, and prices consolidate near or above this metric going into the spring, investors should consider buying select names. A solid hold could be interpreted as evidence that investors have not abandoned the sector en masse just yet. Once the downside is defined, conditions will be ripe for a catalyst (i.e. high-profile takeover) to reignite sector “risk on” sentiment once again.

However, if prices cut through the 100-day EMA like a hot knife through butter, and start to breach around $19.50/share or so, then watch out. It will be compelling indication that investor sentiment has crested long before legalization occurs, and that the market is treating cannabis stocks like any other $5 billion, regulated sector.

The fact that many investors would be caught off-guard by cresting marijuana valuations long before legalization is exactly why we can’t discount this scenario from happening. The market usually performs in ways most traders don’t expect.

Some call it the “max pain” phenomenon; we call it the path of least resistance.

Conclusion

Chartists can certainly use other alphabet-soup technical indicators to gauge market health. But in the end, a bellweather company trading below its 100-MA cannot show industry strength. Again, as goes Canopy Growth Corporation, so goes the sector at large.

Expect the upcoming battle for 100-day EMA (or simple MA, if you prefer) supremacy to be a pitched one. It could be the key indicator gauging investor sentiment down the home stretch. Will we have another rally? Or has the Canadian cannabis trade ended with a loud, echoing thud.

All eyes turn to Canopy Growth to show us the way.