4 warnings for cannabis stock investors about buying into a new market bubble

One drawback of smoking weed is forgetfulness. Why else would investors, who just got badly burned by the cryptocurrency boom, be so willing to invest in pot stocks that are rising so fast?

It is unusual to see multiple bubbles in offbeat asset classes so close to each other. But this is exactly what happens when you mix an overabundance of enthusiasm with a shortage of investable assets in a new and exciting industry.

Back in the late 1990s, all a company had to do to drive its stock price higher was announce a new internet strategy and add “.com” to its name. Both underfunded, old-line companies and IPOs that either went public way too early in their development or had no business being in existence at all had eye-popping stock prices.

Hypercharging the interest were new investment products that focused on this trend as if it were an asset class unto itself. Over the long term, many broad technology funds have done well, but there were also plenty of internet funds that cratered. It was the speculative part of the tech bubble that we refer to today mainly as the dot-com era.

Now there are multiple asset managers trying to get cryptocurrency ETFs approved by the Securities and Exchange Commission, along with marijuana ETFs, one of which passed $1 billion in assets (in Canada), and the ETFMG Alternative Harvest ETF (MJ) in the United States, which is now over $500 million. Diversification is a better option than betting on a single stock in a volatile sector, but did diversification help when the crypto/blockchain bubble popped?

The crypto-craze inflated and popped at warp speed. Overstock.com rose from the mid-teens to almost $90 per share last year because it announced crypto initiatives. It’s down about 70 percent since then, and keep in mind that Overstock.com was a real company with an operating business.

Pot stocks — or cannabis stocks, if you want to use the more respectable name — are rising to unheard-of valuations. Tilray reached a valuation of over $20 billion in wild trading last week that made it larger than companies in the S&P 500. At one point it rose 15 times its trailing 52-week low. Tilray went down almost 50 percent from the high it reached last Thursday, but it still ended last week with a gain of 13 percent and a valuation around $11.5 billion. But by the close of trading on Monday, the entire gain in Tilray shares from last week had been wiped out.

There’s a reason that a hedge fund that shorted the crypto bubble is now focused on marijuana stocks.

Millennials are excited about the cannabis market

Who’s been behind the buying of pot stocks? This is strictly anecdotal, but I have a hunch that just like a pot sector still in its infancy, its investors tend to be young. It’s the millennials. One sign was that Robinhood, the free stock-trading app popular with investors newer to the market, had to suspend purchases in Aurora Cannabis at one point last week — after reports that Coca-Cola was in talks with the company for a cannabis oil–infused drink — because its execution partners were unable to support the large volume of orders. No surprise, the Canadian company is planning to list its share in the United States.

A lot of my clientele are millennials, who also happen to be parents and homeowners, just like every generation before them. So this isn’t a judgment. After all, it was my generation, Gen X, which was the force behind much of the internet stock bubble. Being excited about a new asset class is nothing to be ashamed of, and the recent success of thematic ETFs targeting innovative technologies in areas such as fintech shows that millennial investors do want to be at the forefront of changes in the economy and market. But they also need to know that everyone has to learn the same lessons as the generations before them.

With two bubbles in new asset classes in quick succession, I think it’s worth stepping back and considering whether investors truly understand the marijuana market. I’ve been thinking about it a lot myself. Here is the bullish case, in a nutshell. The meteoric rise in the value of pot stocks generally has to do with the medicinal benefits of cannabis and the legalization efforts popping up globally that are expected to make pot-related products more safe, effective and accessible.

Now here are the reasons to not move so fast, broken down in four thoughts. It’s a mix of warnings about what fuels bubbles in the first place, commodities, regulation and the way stocks are sold when FOMO, the fear-of-missing-out mentality, takes over in the market.

1. Excess liquidity in the system encourages new bubbles.

When you mix an overabundance of enthusiasm with an offbeat asset class that has few investable choices for investors looking for the next big thing, you get an asset bubble. In a broader sense, this flash rally in pot stocks debunks the idea that the Federal Reserve’s interest-rate hikes are taking liquidity out of the financial markets. This is corroborated by the three major averages all trading at or near new highs, with the DJIA having last performed that feat about eight months ago. Excess liquidity is still in the system, which acts as fuel for asset bubbles.

This time just one year ago something very similar was taking place with crypto assets and the blockchain. The three major stock market averages were setting new highs back then, too. Bitcoin became a part of investor vernacular overnight. Then the major stock market averages peaked in January on concerns over rising interest rates and inflation. Bitcoin plunged in value, and the broader crypto bubble popped, leaving investors with massive percentage losses.

2. Pot is a commodity.

It’s used all over America, both legally and illegally. But marijuana is a commodity, and that means if farmers want to grow it, it could become a surplus crop fairly quickly. Any commodity, including the ones that are considered mainstream in the market — metals, oil and natural gas — are subject to booms and busts. You know how bitcoin became a game of who could find the lowest electricity costs in order to profitably mine it.

Pot is a plant, which is ultimately about who has the best farmland to grow it, abundant water and the right weather. No company can escape the ups and downs of its input costs, whether that is agriculture or mining products. I would not underestimate American farmers’ ability to grow marijuana on a large, commercial scale. Companies like Starbucks and Chipotle are always pricing their offerings based on their input costs, coffee and avocados, respectively. Why would cannabis-related companies be able to avoid the same issues?

3. It takes a massive amount of money and expertise to bring an FDA-approved product to market.

A lot of the excitement is around medical marijuana and biotech companies getting into alternative drug therapies using cannabis, not the consumer market. Red Bull and other energy drinks still come up as products that need to be regulated. And there’s similar risk for vaping cartridges that contain nicotine. It seems we’re in a time when accessing consumer products that have other benefits beside hydration and taste is increasing. Alcohol and cigarettes certainly are regulated. You can’t even buy Sudafed without showing your ID to the pharmacy. Regulatory uncertainty in this market should remain a headwind for a long time.

Cannabis-based drugs probably won’t move the revenue needle anytime soon for large drug companies, but they are the ones that have the funding and expertise to develop new FDA-approved products. There’s a parallel to the bitcoin boom here, too: Companies that actually have the ability to develop blockchain products and services, like Alphabet, IBM and J.P. Morgan, won’t see that promise being reflected in their stock prices for a while, which is why investors migrated to the small, speculative niche plays.

4. Oversupply of hot, new stocks will quickly become saturated.

Companies that start out today as “pure pot plays” will take years and many rounds of capital raises to finally turn out a viable product. Leaders will no doubt emerge in this space, but it probably won’t be the small players you’re trading right now. Most of the cannabis stock literature that you read is being pushed by marketers who have a hand in your pocket. And masqueraders will continue to come out of the woodwork. All sorts of companies will miraculously appear that are involved in the pot business, all with a great story to tell. Telling fact from fiction will be nearly impossible.

All of the supply of pot stocks will quickly saturate demand. In other words, don’t get high on your own supply. If a company with no history of earnings and revenue changes its name to something “cannabis”-related and the stock goes up just on that alone, you are welcome to trade it as long as you realize it is purely for speculation.

Remember RIOT Blockchain and Long Block Chain? You can look them up on your own time and decide for yourself if these were worth taking a shot on. Just know that the former was a biotech and the latter was an iced-tea beverage company. By the time you hear about these opportunities, you’re most likely helping someone else sell with a huge profit.

My hope is to help you see clearly through the (sorry) smoke. If you were lucky enough to be in one of these hot pot stocks before it took off, then I’m thrilled for you. Just know that you’d have to be high to think it’s going to be all up from here. If you still feel you want to trade these stocks with money that you can afford to lose, that’s fine, too. But if you’re hastily buying these stocks with the intent of checking out their fundamentals later — sort of like shooting first and asking questions later — then you’re just mindlessly following the bulls and ignoring the bearish case.