Cannabis stocks nosedive as rally driven by hopes for U.S. legal reforms comes to a screeching halt

Tilray Inc. TLRY, -48.98% was down 40%. The stock had gained 50.9% the day before, the biggest one-day gain since it rose 56.8% on March 26, 2020, to close Wednesday at a near two-year high of $63.91. The stock had skyrocketed 148.5% amid a three-day winning streak, before Thursday’s pullback. Aphria Inc. APHA, -33.08% APHA, -30.06%, with which it is merging, was down 28%.

“Things had got too far ahead of themselves,” said Korey Bauer, chief investment officer and portfolio manager of the Cannabis Growth Fund from Foothill Capital Management.

While some of the recent buying appeared to be driven by an investor group on Reddit that had sent the stock of videogame retailer GameStop Inc. to record heights in recent weeks, “we’ve also had record flows into exchange-traded funds and mutual funds in the last few weeks,” said Bauer.

“There’s been a massive move, and most people are buying Canadian cannabis stocks, which are not going to be the direct beneficiaries of any reforms of laws in the U.S. It’s been pretty rough with these moves,” he said.

The rally was ignited by the election of President Joe Biden and Vice President Kamala Harris, both of whom are viewed as in favor of reforming the U.S.’s strict federal cannabis laws, which, despite the progress made by proponents of medical marijuana, continue to classify it as a Schedule I drug, alongside the likes of heroin.

That has hampered the development of the legal market, which is confined to those states that have legalized cannabis for medical or recreational use, and kept companies largely out of the federally insured banking system.

With more states voting to legalize in November ballots, and New York expected to come on board this year and create a market rivaling that of California, investors are looking at the sector with renewed interest.

“There is reason for optimism, and clearly these micro and macro factors, combined with reasonable valuations, have grabbed the attention of many investors,” said Jason Wilson, banking and cannabis expert at ETFMG, the issuer of the MJ ETF MJ, -24.06%. “But while the cannabis industry is clearly growing globally, and many cannabis companies are on a path to profitability, the recent rally in cannabis stock prices appears to be becoming overly exuberant.”

Even amid Thursday’s 40% decline, Tilray, for example, remains up 129% in the last 12 months, in spite of its continued loss making and struggle to grow revenue.

Tilray is the most shorted stock in the cannabis sector, with short interest representing 23.1% of the public float through Wednesday, according to S3 Partners LLC. But despite this big short position, the recent rally wasn’t a result of a short squeeze.

Data: The most shorted stocks in the U.S. as of the end of January

Ihor Dusaniwsky, managing director of predictive analytics at S3, said bearish bets on Tilray have actually increased this year. The value of shares shorted was $1.33 billion, up more than $1 billion since the company announced its merger with Aphria in December.

Despite the head start that Canadian companies enjoy in cannabis — Canada fully legalized the plant for adult recreational use in October of 2018 — companies have struggled to achieve profitability as the rollout lagged expectations and red tape hampered the opening of retail stores. That allowed the black market to thrive and compete with the legal sector, where prices are higher.

“There’s major oversupply in Canada and definitely some risk in Canadian names,” said Bauer. “We still think some of the U.S. multistate operators are attractive, but because they’re not listed on major exchanges, there’s a disconnect between U.S. and Canadian valuations.”

Because of the federal ban, U.S. cannabis companies trade over-the-counter or on Canadian exchanges, although there is growing optimism that will change soon.

Senate Majority Leader Chuck Schumer and two of his Democratic colleagues have pledged to bring cannabis legislation before the current Congress. That has raised hopes for at least safe-harbor banking language, which would grant companies access to banks and crack open the capital markets.

Read now: Cannabis stocks rally after Chuck Schumer leads drive for reforms that may end federal prohibition

“Anything that would allow U.S. companies to uplist would be extremely beneficial,” said Bauer.

In the meantime, investors should fasten their seat belts.

“Given the very strong price gains over the last few days, I would expect to see volatility in cannabis stock prices as we start to see downward pressure relating to profit taking and potential short selling,” said Wilson.

Smoke Wallin, chief executive of Vertical Wellness, a maker of CBD-based wellness products, agreed but said individual investors getting into the space right now are making the right move in anticipation of a flood of institutional money once rules are relaxed.

“That’s not to say that any individual trading of stocks up and down makes sense at today’s valuations,” he said. “But any holders who believe the fundamental shift to a broad-based national legal cannabis market are going be highly rewarded.”

 With a large crop of private companies prepping to enter the market in the next 12 to 18 months, there will be more targets for acquisitions, he said.

“So there’s going be a lot of M&A over the next 12 months, there’s going be a lot of capital flowing in, and I think the individual tickers, they’re going to go up and down, with volatility,” said Wallin.