In over 10 years of writing and growing the Equedia Letter to become one of the largest investment newsletters in North America, I have never witnessed such momentum and interest in one particular sector.
Not only are investors investing in marijuana stocks, but people that have never invested before are bombarding our mailboxes with questions on how to begin their investment journey.
That is both exciting and worrisome at the same time.
It’s exciting because investors are the foundation of growth and innovation – without them, there is no capital to advance technologies, no capital to create millions of jobs, and no capital to help the economy grow.
But this is also worrisome because new investors – as excited as they are – don’t fully understand the risks involved.
Their euphoria has sparked one of the most significant sector booms of our generation, paving the way for incredibly high valuations and a massive influx of capital.
The question now is: where do marijuana stocks go from here?
To answer that, let’s step back from the euphoria to better understand the market as a whole.
Today, I want to share with you where I think we are in the current market cycle and dispel many of the investing myths you may have read in the past.
From there, I will share where I think the marijuana sector is headed based on its current cycle and how I am looking to invest in the space now that legalization in Canada is official.
How the Best Investors Think
The most important thing to remember is that we can never be 100% sure of what is going to happen.
In fact, you could say investing merely is educated gambling.
The best investors don’t know what’s going to happen. But they understand the many possible scenarios that could happen and know how to assign a probability of their likelihood to play out.
Imagine a roulette wheel at the casino. You see an equal number of red and black pockets, and a maybe one or two green ones.
Each red, black, or green pocket on the wheel represents a potential scenario; red could be a positive scenario, black could be a negative, and green is the outlier where you can make a ton of money.
Now imagine being able to influence that wheel with more reds or more blacks.
You still can’t be sure where that ball will land, but if you bet on red when there are more red pockets, the probability of making money is much higher.
The key to assigning this probability is understanding where the current market cycle is.
For example, if stock prices are high and the psychology of the market is mostly positive, it becomes harder to make money because prices are mostly elevated.
This could mean we’re high in the cycle since many of the positive scenarios that drove the market higher have already happened. In this scenario, there are fewer reds on the wheel.
Conversely, if stock prices are low and the psychology of the market is mostly negative, it might be easier to make money.
This could mean we’re at the lower end of the cycle, leaving fewer blacks on the wheel since many of the negative scenarios have already happened.
So where are we in the current market cycle?
The Ultimate Debt Transfer
Where we are in the market cycle can be summed up in a Letter I wrote three years ago, titled, “The Ultimate Bailout Plan: The Fed’s True Plan:”
“Eventually, the Fed will have to begin winding down its assets, which means there will be a lot of bonds to soak up.
Foreign liquidity won’t be able to soak up all that has been printed. That means money will have to come from somewhere else. And that somewhere – I believe – is from the stock market.
If the stock market continues to climb, it will create more liquidity for bonds. Why? Because the stock market will eventually correct at some point, and when it does, investors will seek the safety of bonds; thus, soaking up much of the bonds held by the Fed.
The higher the stock market climbs, the more money is available for bonds on the way down.
This is the Fed’s true plan.”
A year ago, the Fed began unwinding its US$4 trillion of Treasury bonds and mortgage-backed securities, liquidating tens of billions of dollars each month.
In fact, what began at just $10 billion per month in Q4 2017, soon became $20 billion per month…then $30 billion…then $40 billion…and is now on track to hit $50 billion per month.
Take a look:
Now recall what I wrote in March:
“With a Federal budget expected to exceed US$1 trillion starting in 2019, the US will have to sell more Treasury securities. A lot more.
And it will have to do it during a time when the Fed is also unwinding the US bonds it has on its balance sheet.”
And how has that played out?
“…All that debt piling up in the government’s coffers is going to require the Treasury Department to get more creative in figuring out how to finance it.
As a result, the department said Wednesday (Aug 1, 2018) it needs to sell an additional $30 billion worth of bonds in the second quarter and is adding a two-month note to the offering of debt securities. That compares to a $27 billion increase for the first quarter.
In its quarterly refunding statement, the Treasury said it will be adding another $1 billion a month to each of the auctions for two-, three- and five-year notes over the next three months.
On top of that, it will increase the auction size for the seven- and 10-year notes and the 30-year bond by $1 billion for the August sales.”
In other words, while the Fed unloads its balance sheet to the tune of $50 billion a month, the US is steadily increasing its issuance of new bonds to accommodate its growing deficit.
And what happens when so many bonds hit the market at once?
Raise Those Rates
When so many bonds hit the market, the inevitable outcome is a rise in overall interest rates.
“With the abundance of US bond supply expected to hit the market, better bond terms will likely be required in order to compete for capital – especially since yields are still near all-time lows.
That means yields will eventually have to go up.
In Layman, interest rates will have to rise.”
Here’s a look at the Fed Funds Rate since the Fed began unwinding:
And what happens as interest rates rise?
Via my Letter from April, How Tariffs Really Affect the Market:
“…if interest rates rise, capital will shift from the equity markets over to the bond market.”
And that’s precisely what is happening.
“…Investors poured just over $19 billion into bond funds for August, compared with a net withdrawal of $1.4 billion for U.S. stock-focused funds, according to data this week (September 2018) from Morningstar.
…Over the past year, flows in mutual funds and exchange-traded funds combined have told a disparate story – $293.2 billion has gone into bonds, while just $4.5 billion has found its way into U.S. equities.“
In other words, the Fed’s transfer of debt to the people is working.
In fact, US Households are now the biggest buyers of Treasuries – by a long shot.
Via Business Insider:
“Treasury demand from US households dwarfed that of the next-highest category, RoW (rest of world).
‘Households remained the largest buyer of Treasuries for the second quarter in a row, and they have purchased 46% of the net Treasury supply so far this year,’ MS said.”
Which is why I suggested in July:
“It wouldn’t be a bad idea to start looking at ETFs that take advantage of a rise in bond yields.
Since bond prices drop as yield rises, ETFs that “short” bond prices will benefit if that scenario plays out.
Some of them include the Proshares Short 20 Plus Year Treasury (TBF) which uses no leverage, the Proshares UltraShort Lehman 20 Plus Year Treasury (TBT) which uses double leverage, and the Direxion Daily 20 Plus Year Bear 3 Shares (TMV) which uses triple leverage.”
Here’s how the TBF has performed:
And if you took the additional risk through the triple-leverage TMV, you’d be up over 22% in less than three months, and up to nearly 28% if you cashed out at the top of the chart:
I suspect that we’ll continue to see further US equities outflows and more bond inflows to support the exodus of bonds from the Fed’s balance sheet.
In other words, the world’s richest and most powerful entity, the Federal Reserve, is now in deleveraging mode – that is where we are in the market cycle.
The question for the market now is how far and how fast the Fed will go in both unloading its balance sheet while raising rates to accommodate that unwind.
The Domino Effect
Over the past years, there has been one common theme I have painted with regards to where we are in the market cycle.
That is, history does not repeat itself, but it rhymes (yes, it’s a famous quote often attributed to Mark Twain.)
For example, in January, I wrote:
“When we think of how overvalued the market is, or how frothy the market has become, we rarely consider what that truly means.
Sure, when compared to historical data, the market is higher and rising faster than ever.
But by today’s standards, is it really rising that fast?
Are stocks really that overbought?
The more gum we chew, the bigger the bubble…
The more money we create, the bigger the market.”
In other words, no market cycle has never been the same – the speed at which it rises, how much it rises, how long it goes for – it’s always different.
The market continues to show signs of strength through strong economic numbers and low unemployment, but investing in today’s market certainly poses a much higher risk than it did five years ago.
And while the banks today aren’t nearly as leveraged as they were in 2007 and we don’t (yet) have a potential mortgage crisis like that of 2008, what we do have is a lot of debt – especially corporate debt.
More than four years ago, I walked you through how the Fed influences the stock market:
“Since Fed policy dictates that it cannot directly buy stocks, the Fed has found other ways to encourage people to take risks.
…One of these strategies is to force banks to lend.
The problem, however, is that it’s difficult for banks to lend to unqualified borrowers. And since the majority of Americans have been terribly affected by the economic crisis, many of them don’t meet the requirements for borrowing.
With so much stimulus, where has all the money gone?
To the people who meet the requirements: big corporations with cash.
Remember a while back when I talked about the record amount of cash hoarding by big corporations and how they weren’t using it for capital investments (hiring, infrastructure, etc.) because the economy didn’t warrant such actions?
So what do you do when you have so much cash, but nowhere to deploy it?
Invest in the stock market…simple!
Since spending didn’t make sense for these corporations, as the economy truly didn’t warrant further hiring or sales, these companies decided to buy a record amount of their own stock with their cash pile.
When a company issues a share buyback, the amount of outstanding shares in a company decreases. This leads to a higher Earnings Per Share (EPS), which makes the stock look much more attractive. This, of course, leads to higher share prices.
…Share buybacks continue at record pace, and I expect billions of dollars in transactions over the next few months alone.”
And boy was that assumption right.
Today, US corporate debt has reached a record US$6.3 trillion.
As a result of cheap money and corporate share buybacks, corporations are now more leveraged than ever.
The good news is that U.S. companies have a record $2.1 trillion in cash to service that debt.
The bad news is most of that cash belongs to a few of the biggest companies.
“…the riskiest borrowers are more leveraged than they were even during the financial crisis, according to S&P’s analysis, which looked at 2017 year-end balance sheets for non-financial corporations.
On first glance, total debt has risen roughly $2.7 trillion over the past five years, with cash as a percentage of debt hovering around 33 percent for U.S. companies, flat compared to 2016.
But removing the top 25 cash holders from the equation paints a grimmer picture.
Speculative-grade borrowers, for example, reached a new record-low cash-to-debt ratio of just 12 percent in 2017, below the 14 percent reported in 2008 during the crisis.
“These borrowers have $8 of debt for every $1 of cash,” wrote Andrew Chang, primary credit analyst at S&P Global. “We note these borrowers, many sponsor-owned, borrowed significant amounts under extremely favourable terms in a benign credit market to finance their buyouts at an ever-increasing purchase multiple without effectively improving their liquidity profiles.
The trend persists even among highly rated borrowers: More than 450 investment-grade companies not among the top 1 percent of cash-rich issuers have cash-to-debt ratios more similar to those of speculative issuers, hovering around 21 percent.”
With interest rates rising, there’s a chance many US companies will struggle to service the massive amount of debt they accumulated in the past decade. If that happens, they will have to cut costs which generally means laying off workers.
And we know what happens to the economy when mass layoffs occur.
It’s hard to say what will cause this giant credit bubble to finally pop. We are now 9.6 years into the current bull market and more than 9 years into an economic recovery, of which the longest US economic recovery has been 10 years.
When you consider that most financial crises happen every 10 years, that certainly is a cause for concern.
But going back to the theme of history doesn’t repeat itself, but it rhymes, means we shouldn’t take all of this at face value.
Remember, records are made to be broken.
And while we’re nearing the 10th year of a recovery, it’s also been the slowest US recovery we have ever had. Sometimes, slow and steady wins the race. Could a slower recovery lead to a longer one? Maybe…
If we witness a drop in the stock market of 10 – even 20 – percent, should we be worried? What if after that drop, we immediately see a 50% rise?
In other words, it’s time to be cautious, but not downright frightful.
I have been hearing that the market is overvalued from very smart people for a very long time.
Yet, I keep telling them that they’re going to miss out on a lot of profits by staying out of the market.
And I have been right up to this point.
Ironically, those “smart people” who told me the market is overvalued continued to invest the whole time they were telling me the market was overvalued.
There are now more blacks than reds on the roulette wheel. That doesn’t mean the ball can’t continue to land on red.
Move forward, but with caution.
Landing on Green
What about those green pockets on the roulette wheel?
In every market, there are always outliers that provide incredible money-making opportunities for investors.
And in this market, those green pockets – coincidentally – represent marijuana stocks.
I don’t have to tell you just how much money has been made in marijuana stocks over the last three years.
In fact, you’ve probably traded tons of them for great profits – including one of our earlier ideas this year whose share price more than doubled in just a month’s time.
But now that legalization has officially happened, most marijuana stocks have declined – with the largest marijuana ETF (HMMJ) falling nearly 8% in just a few days.
This has led to the question: is the marijuana run over?
The Marijuana Cycle
Every business has a cycle, and it’s generally assumed they are as follows: expansion, peak, contraction, and trough.
If the business is sustainable, the cycles repeat and eventually trend higher over time.
The question is whether or not the marijuana cycle has reached its current peak. Given the profit-taking that has occurred in the last few days alone, one could easily argue that it has.
But because there are so many variables when it comes to marijuana stocks – many of them political – the contraction and troughs could be very short-lived, leading to further expansion and new peaks in the coming months and years.
So while we may see further weakness and volatility, I don’t think the run is over – not even close.
For example, it will take at least a few quarters of earnings for people to gauge just how strong the marijuana market is in Canada.
And even then earnings won’t be an accurate indicator of market potential since the majority of Licensed Producers won’t be growing at full capacity until at least the second half of 2019.
In other words, marijuana stocks will continue to see high valuations because it will take at least a year – maybe more – for supply to catch up with demand.
Furthermore, the regulations for edibles and other marijuana-related products have yet to be resolved, and many of those won’t hit the market for some time.
When they do, it will pave the way for even further growth.
And I haven’t even begun to talk about what could be the most significant announcement of all…
US to Legalize Marijuana?
The US continues to become more accommodating to marijuana.
Earlier this year, US Attorney General Jeff Sessions said he would continue to crack down on marijuana – regardless of individual state laws.
It didn’t take long for Donald Trump to refute those comments by stating that he would likely support a legislative proposal to leave the decision to states about whether to legalize marijuana.
Last month, marijuana stocks sold off as a result of comments by US border officials, stating Canadian marijuana investors and workers could be turned away at the border:
Via Financial Post:
“U.S. officials warn any form of participation – including working – in the marijuana sector could render someone inadmissible.”
Ironically, a few days later, the U.S. Drug Enforcement Administration agency gave a Canadian Marijuana producer approval to export a medical cannabis product south of the border for use in a clinical trial.
It’s no wonder it didn’t take long for US Customs and Border Protection to change their tune.
“U.S. Customs and Border Protection says Canadian citizens working in the cannabis industry should be able to enter the U.S. for reasons unrelated to the marijuana industry.
The agency updated its website Tuesday, providing a measure of clarity after a vague statement last month left the industry and investors facing uncertainty about travel of any kind to the U.S.”
Marijuana is also up for consideration in Michigan, North Dakota, Missouri, and Utah. If passed, the first two initiatives would legalize recreational marijuana, joining nine other states and Washington, D.C.
And you can bet that the passing of any new marijuana laws in the US will fuel the marijuana market even further.
Last, and the most significant spark of all, is the potential for a Federal US announcement on being more marijuana-friendly.
It may not be all-out federal legalization, but if President Trump passes legislation to allow each individual state to handle marijuana, it could be the biggest boon for marijuana stocks ever – much, much bigger than what we have seen in Canada.
And I suspect that could happen sooner than many expect…
Trump Wants a Second Term
Trump is no idiot – he is the President of the United States, after all.
And you can bet he wants to win.
The US economy is booming, and unemployment numbers are low.
Despite all of the positive US economic indicators under the Trump administration, Trump will continue to be bombarded with negativity amongst the media to sway votes against him.
With the mid-term election just two weeks away, it wouldn’t surprise me if Trump makes an announcement in support of marijuana to sway votes in his favour.
He knows he needs both the House and Senate not only to maintain the power he has had in the past two years but to prevent the potential of impeachment.
Via Straits Times:
“If Republicans maintain control of the Senate, the chances that Trump might be impeached drop sharply – barring any major new scandal – because senators have the final word in these rare efforts to depose a president.
Trump could also continue pushing through his conservative judicial nominees, especially if there is another opening in the powerful Supreme Court, the final legal arbiter on the country’s biggest and most socially sensitive questions.
‘Democrats have lots of opportunities in the House, but not really the Senate,’ said Kyle Kondik, managing editor of a nonpartisan political newsletter at the University of Virginia Center for Politics.
…If Democrats do take control of the House they will be in a position to launch vigorous inquiries into the Trump administration’s policies and behaviour, and to block Republican-backed laws from passing, including a vote on the federal budget – essentially giving them the leverage to paralyse Washington.”
Trump knows the US midterm elections in the coming weeks are crucial.
So it’s no surprise that his opposition is already using marijuana to sway votes.
“A key Democratic congressman has a step-by-step plan to enact the end of federal marijuana prohibition in 2019 if his party takes control of the House…
…’Congress is out of step with the American people and the states on cannabis,’ Rep. Earl Blumenauer (D-OR) writes in the eight-page document addressed to House Democratic Leadership. ‘We have an opportunity to correct course if Democrats win big in November.
There’s no question: cannabis prohibition will end. Democrats should lead the way.'”
If Trump loses the House after the US midterm, I would bet that he pulls out all the stops in the 2020 US election.
And I believe that could include some form of marijuana legalization – the green pocket on the roulette wheel.
As I mentioned earlier, move forward with caution – and that’s precisely what I am doing.
I remain very cash heavy, but not out of the market.
I have taken profits on many marijuana stocks, but I am putting a lot of it back into new ones that better align with the current marijuana cycle.
Those listed, or going to be listed, on a major US exchange likely have the upper hand as they provide much more liquidity and exposure than others – especially if some sort of US law passes on being more marijuana-friendly.
I also suggest looking at retail plays that have deep roots in retail stores and chains, and not just brands.
That’s because these stores are going to be the next big drivers for marijuana. They will be the middlemen – the cash conduits – for the big Licensed Producers
Right now, very few retail chains exist.
But come next month, many of them will open and the rush to buy legal weed will truly be on.
Seek the truth,
The Equedia Letter
We own shares of many marijuana stocks and will benefit from their rise in share price.
Equedia.com and Equedia Network Corporation are not registered as investment advisers, broker-dealers or other securities professionals with any financial or securities regulatory authority. Remember, past performance is not indicative of future performance. This article also contains forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from the forward-looking statements made in this article. Just because many of the companies in our previous Equedia Reports have done well, doesn’t mean they all will. Furthermore, we are biased toward marijuana stocks as we own shares in many of them.