Canopy Growth Corporation (TSE:WEED) (OTCMKTS:TWMJF) (FRA:11L1), Aurora Cannabis Inc (TSE:ACB) (OTCQB:ACBFF) (FRA:21P), and Cronos Group Inc. (CVE:CRON) (NASDAQ:CRON) all had big days affecting the performance of the S&P/TSX Composite Index (INDEXTSI:OSPTX) today.

Marijuana stocks had to calm down at some point. The extreme volatility exhibited from late December to early March has finally abated into what some may characterize as “lifeless” trade. The wild swings have morphed into a consolidation setup, where bulls and bears jostle for directional supremacy. As such, we examine which upcoming catalysts could break the sector status quo.

If you are a daily reader of the Midas Letter, this consolidation shouldn’t come as a surprise. Back on March 7, we published an article titled Canopy Growth Corp and Cronos Group Inc Helped Propel Cannabis Stocks 28% In Five Days—What Comes Next? predicting this very event.

Although sector leader Canopy Growth Corp. (TSE:WEED) (OTCMKTS:TWMJF) helped pull the market out of its February dive by announcing plans to dual-list on the NASDAQ stock exchange, it wasn’t a paradigm-altering catalyst worthy of continued extension. The news was powerful enough to break the recent correction and take marijuana stocks back to the February 7 swing high, but that’s about it. Prices have stalled out since, as investors have taken a clear wait-and-see approach during the last week.

Certainly, a choppier news cycle has contributed to the direction-less trade. The market appears to be confronted with stronger headwinds than at any time since the legalization hangover experienced in summer 2017.

For instance, the Canadian marijuana legalization timeline has come under pressure recently as Senate Conservatives balk at issues pertaining to Bill C-46. This legislation was co-tabled along with the main marijuana legalization legislation—Bill C-45—to strengthen inadequate legal frameworks surrounding cannabis-induced impaired driving. Although Bill C-45 stipulates cannabis will become legal at a date set by cabinet, it will be illegal to transport cannabis without royal assent (ratification by both House and Senate). The fuss surrounding Bill C-46, which some senators have called “unconstitutional” and “full of holes”, threatens to derail the government’s full legalization timeline.

There’s also questions about future profitability in some segments of the market. This evidence comes via the Canadian government’s own studies which show declining street cannabis prices on the black market between 2011-2015. This is backed up by more recent findings which show cannabis prices in Canada were C$7.43/gram in 2017, the lowest since 1981.

Canopy Growth CEO Bruce Linton weighed-in on the subject recently at the Economic Club of Canada. He essentially compared cannabis to other mundane agricultural cash crops, “Low cost of production is a big deal, but (cannabis is) only an ingredient. It’s about as exciting over the next three, or four, or five years as the price of sugar in the context of any finished good that uses sugar.” Obviously, there is little inspiration to be found in those comments.

Furthermore, there’s ample evidence that cannabis prices tend to fall in jurisdictions in which legalization is enacted. Often times, the declines are dramatic. As recently as last year in Colorado, cannabis prices dropped up to 40 percent YoY in the first half of 2017 compared to 2016. A similar dynamic has occurred in Oregon, best exemplified by this tweet:

Canada’s #Cannabis Price Index Oregon $50 Oz (taxes included)…. Ontario $336 Oz + $28 Cannabis Tax + HST $54 = $418 That’s a $368 difference. Not including gas cost to drive to these far off locations in Ontario.#PotStocks pic.twitter.com/2YcdWeX4dL — Betting Bruiser (@BettingBruiser) March 5, 2018

Is the government’s $6.2 billion cannabis market projection over-optimistic if the shadow black market slashes prices downward towards $5/gram (In Oregon, the retail price in some location is less than $2/gram!)? Remember, the Federal government is looking to establish a benchmark price of double that amount.

It light of these facts, valuation questions have become more acute. While the large international cannabis conglomerates have ample room to grow into frothy valuations by deriving margin benefits through refined medicinal and premium branded products, a significant portion may not. It’s that lower quadrant of which may be limiting sector sentiment at the moment.

Catalysts To Break The Deadlock

In my view, the consolidation will continue apace until marijuana stocks gain more visibility.

On the bull side, you have high latent investor demand as witnessed in recent Cronos Group Inc (CVE:MJN) (NASDAQ:CRON) recent stock activity. Strong sector sentiment continues to remain firm, despite the recent decline. Until listed companies actually start publishing financial results, the ‘Goldilox’ mentality driving the ‘bubble’ will likely remain in place. Regardless of the vicious downswing experienced in prices, the technical damage has been limited—and is in fact improving.

On the bear side, legalization skittishness, valuation concerns (mainly producers with under-branded product lines) and a slowing of ‘risk-off’ sentiment has weighed on the sector.

In the author’s opinion, the consolidation will continue until that next undefined catalyst comes to the forefront. With bulls and bears at equilibrium, investors aren’t rushing to deploy capital. But in the coming weeks, news will certainly materialize and shatter the current paradigm. Below are some likely events which could ignite just that:

Another large marijuana stocks merger is announced (there hasn’t been one since January 2018)

The path toward legalization by way of royal assent gains clarity

Brisk American demand for Canopy Growth stock overwhelms the bid, raising all sector participants

The wildcard: Green Organic Dutchman Holdings (which many have called the biggest cannabis IPO of 2018) debuts strongly and re-ignites investors animal spirits

Keep in mind, Aurora Cannabis Inc (TSE:ACB) owns an 17.62% interest in Green Organic Dutchman Holdings, with the option of incrementally increasing its ownership interest to over 50% upon achieving certain operational milestones. A strong IPO showing will provide a significant boost to Aurora Cannabis, who is poised to become the co-sector leader in the space soon.

Also keep in mind that sector catalysts work both ways. If the above scenarios fail to materialize in due course, it may prompt a sector sell-off. Expensive markets can last awhile, but only if a steady stream on positive news is injected into the market. Investors are betting on expectations of future profits, and will gladly deploy money elsewhere if reasons for such expectations fall short.

Life Sciences Cannabis Companies Will Lead the Way

I think it’s important to distinguish the Life Science cannabis stocks from the recreational marijuana stocks. The former is much less exposed to pricing power risk and black market supply for profits. Life Sciences are generally more diversified, produce higher margin products and have more exposure internationally. In essence, the cannabis “market” is really a tale of two sub-sectors.

Thus, when looking for sector leadership, we turn to the Horizon Medical Marijuana Life Sciences ETF (TSE:HMMJ) for answers. This ETF is filled with the best capitalized and more diversified names in the sector. Leadership always starts at the top. The sector can only break out if the Life Sciences segment participates.

As updated chart regarding our current areas of interest is posted below:

Midas Letter will continue publishing weekly updates as the market makes up its mind.

Until then, happy investing.