Ted Ohashi's Marijuana Stock Market Review & Outlook for 2019

Introduction: 2018 was a most challenging year for cannabis investors. It was a year marked with several outstanding developments offset by some negative events that had not been seen in the short history of Canadian public companies. Throw in some allegations made toward one of the leading Licensed Producers listed on the New York and Toronto Stock Exchanges that have not been properly addressed and you have investors looking forward to a better 2019.

From my perspective, the year, and especially the past six months, have been more or less as expected. We have been cautious toward the cannabis group, especially later in the year when we warned that 2018 was a perfect year to expect tax loss selling that could have a depressing effect on the cannabis group until Christmas. That was the bad news. The good news is I expected the cannabis stocks and equities in general to rebound after Christmas and the end of tax loss selling. In looking at the two days of post-Christmas trading in Canada, it seems evident that tax loss selling pressure has abated and the cannabis group seems poised to make an upward move into the new year.

I am sticking with my earlier forecast. I see clear sailing into the first quarter of 2019.

The U.S. markets staggered into the final month of the year. The day before Christmas witnessed the worst points decline in the Dow in history followed by a record points gain the day after Christmas. However, as can be seen in both the one year (above) and five year (below) charts, there was some signs of life despite this volatility. We are bullish for 2019 because going back to 1940 the Dow Jones Industrial Average has never declined in a post midterm election year. It is because incumbent Presidents want a strong economy going into the next election and for that to happen the time to act is now. This might apply more strongly for President Trump because he has little left to hang his political hat on than the economy and the stock market. If he’s going to carry the rust belt states that gave him the presidency last time, he will need a strong economy again this time.

Here is the Toronto Stock Exchange Composite Index. The pattern looks similar to that of the U.S. as we are in an economic bed with the U.S. elephant. Our indexes are more heavily weighted toward the resource sectors that have been weak and more recently the crude oil markets have been in a downtrend as well. But if the U.S. market turns in a strong performance in 2019 as I expect, our overall results will be closely linked.

Here is a look at the LTB Composite Index. It shows the cannabis stocks were declining almost all year. The rally to higher levels ended in December 2017/January 2018 when U.S. Attorney General Jeff Sessions rescinded the Cole Memorandum and spooked investors that he would do more. In actual fact, the U.S. cannabis movement made considerable headway under Jeff Sessions as more states legalized medical and/or recreational marijuana.

In looking ahead at 2019, I see the Canadian cannabis stocks pulled upward by companies operating in the U.S. In other words, I continue to believe the U.S. based companies will outperform their Canadian counterparts. In Canada, I think enthusiasm will be dampened by ongoing shortages of legal cannabis, resolution of some of the existing scandals including in chronological order: Ascent Industries, Aphria, and, most recently, Bonify. There may be more scandals to come. In addition to the United States, I expect attention will be drawn to Latin America, South American and Europe. With South Korea and Thailand legalizing medical marijuana later in the year, there might be some surprises out of Asia as well.

These charts show the relative performance of the Canadian and U.S. Marijuana Index (CMI) published by MJIC. If the graph rises to the right, it means the U.S. Index is outperforming the Canadian Index. This can happen because the U.S. stocks are rising faster or falling slower than their Canadian counterparts. The chart to the right shows the U.S. stocks have been outperforming consistently for the past year and the longer term chart to the right shows the U.S. stocks were underperforming but that changed around a year ago. These graphs illustrate that my expectation that the U.S. sector will outperform the Canadian sector is a forecast that the trend established in the past year will continue.

Regular readers will recognize these momentum charts. We use momentum to confirm price trends. If prices and momentum diverge, we always follow momentum. What the charts show is that in both the one year (above) and the five year (below), momentum has been trending down. I interpret this to mean that fewer and fewer stocks are participating in the upward trend in prices. We have mentioned in the past that this trend suggests that stock selection is becoming more and more important. In other words, it is much more difficult to be a successful cannabis investor in 2019 compared with 2013. The low hanging fruit has been picked. I will do my best to guide readers to the more profitable areas of cannabis investment and I urge readers to find and follow proven, professional advisors.

Here we look at the short (above) and longer term (below) performance of the Licensed Producers. The LPs are generally the larger and better financed companies in the cannabis group in Canada. We believe it is healthier for the markets if the LPs outperform the average cannabis stock. This has generally been the case although the group also suffered losses in 2018.

Next we look at the short (above) and longer term (below) performance of the Licensed Producers relative to the LTB Marijuana Composite Index. This makes it clear that even in a down market, the LP stocks outperformed the typical cannabis stock. This should come as no surprise since LPs such as Canopy, Cronos and Tilray had major positive events to report. Of course there were negatives for investors to contend with primarily, Ascent that is facing the possible revocation of their Health Canada licenses and Aphria that is yet to respond to serious allegations made by short sellers Hindenburg Research and Quintessential Capital. To a lesser extent, Liberty Health Sciences (CSE: LHS) is in the same boat as Aphria. Nonetheless, I think careful security selection from the list of LPs is a good way to go in 2019.

The next two graphs plot the short term (above) and longer term (below) price trends for the cannabis stocks trading under $.10 per share. We are not so much interested in the price trends as we are in using these as a mandate for cannabis investor psychology. If this group of stocks is performing well, there must be a relatively high degree of optimism and willingness to speculate. This, in turn, is a contrarian indicator. An uptrend in cannabis stock prices is more likely to continue if the degree of speculative psychology is lower. At present levels, the index is low suggesting the willingness to speculate is also low. This is positive for the cannabis group as a whole.

This chart follows the length of rallies and corrections in the LTB Marijuana Composite Index and compares it to the historical record. It reveals that the current upturn is two weeks long and it can continue in this direction for another two to four weeks before it challenges past norms. A this point there is nothing in this graph that gives us reason for concern. Several past rallies have lasted between three and six weeks.

Conclusion: For some time we have been looking for cannabis stock prices to remain weak until after tax loss selling season in Canada. After that we have called for a rally in stock prices moving into the new year led by the conventional indexes such as the Dow Jones and Toronto Stock Exchange Composite. Although the indexes appear to be following my script to a tee, I am not ready to skate around the rink holding the cup above my head just yet. But for those you who have been holding off on purchases of a favourite stock or two, now would be a good time to act.

International market returns: it was a difficult year for common stock investors. Of the world indexes we follow, only one (India) managed to show a positive one year return. It is worth noting that the cannabis returns are clustered at the bottom end of the return rankings. The LTB Marijuana Composite and Licensed Producer indexes are marked by the gold arrows while the Toronto Stock Exchange and the Toronto Stock Exchange Venture are identified by the red arrows.

As we have talked about several times, the cannabis stocks have above average volatility or what is referred to as “high beta,” This should come as no surprise. If the cannabis group is to generate above average returns, it must be more volatile by definition. Don’t be concerned. This is the buying opportunity we have been waiting for. It is time to take advantage.

The one year returns were:

• TSX/SP Composite -12.3%

• LTB Licensed Producers: -25.7%

• TSX Venture -34.5%

• LTB Marijuana Composite -36.0%

The remaining international markets ranged from India +6.6% to China at -22.7%.

Recognizing that past performance does not guarantee future results, if an investor had allocated 20% of a Toronto Stock Exchange portfolio to the cannabis sector as measured by the Let’s Toke Business Marijuana Composite Index since inception, the amount of capital available would increase by fivefold. Put another way, if you have 30 years to retirement and you contribute $250 per month and you earn the average return from the S&P/TSX Composite last year ignoring taxes, your capital pool will be worth $103,277. By comparison, if you had earned a return equivalent to allocating 20% of your TSX portfolio into cannabis stocks and earned the LTB Marijuana Composite Index return since inception including the poor returns in 2018, your savings would increase to $671,287. This is an increase of 550%. If you had chosen instead to invest 20% of your portfolio in the LTB Licensed Producer Index since inception, again taking into account the low returns for the cannabis sector in 2018, your savings would be worth $8,881,063. This is not a forecast but is intended as an indication of the benefit that is possible by simply diversifying a part of your portfolio to the cannabis group.

We are not presenting this as a forecast because, as we said above, past performance is not indicative of future results. So we are not projecting these rates of return for common stocks in general or the cannabis stocks in particular. But we are confident that the general rule will apply over time. Cannabis will continue to be an above average growth sector and diversification into cannabis stocks can make a dramatic difference to the amount of retirement capital you accumulate.

Conclusion: we have expressed caution for several weeks, most recently because the market action in the cannabis stocks during the year indicated that tax loss selling would be an important factor in depressing the group this year. At the same time we anticipated a recovery when tax loss selling ended after Christmas. That time has passed and the cannabis stocks have shown some positive signs. We have advised portfolio investors to hold some cash and we think this is the time to spend some. If you didn’t raise any cash reserves, hang on to the stocks you have and ensure the ones you own offer the best growth prospects. Security selection is more important than ever moving forward. 2019 is shaping up to be a much better year than 2018 in our opinion.