Pot Stocks: High Alert!

RoboStreet – November 8, 2018

Referendum on Pot Legalization Gains After Midterms

Leading up to the post-election rally, earnings from high-profile companies dominated the attention of the financial media and investors alike with a tremendous amount of debate as to whether the third quarter represented an earnings peak for the current economic cycle. This topic was also heavily talked about for both the first and second quarters of this yearand yet the economy continues to pleasantly surprise investors and frustrate the naysayers.

For many big-name stocks, selling on the earnings news had been the order of the day, especially if results failed to produce a huge upside surprise for revenues and sales. Before the market reversed itself on October 31,the only sectors getting any love from investors were utilities, real estate, and a few consumer staples as the appetite for safety and yield ruled sentiment. Roughly 90% of all stocks are trading well off their late September highs, some high-PE growth stocks as much as 40%-50%.

The selloff levied heavy technical damage and took a big toll on investor sentiment as the forced selling by ETFs and computer program selling gives a sense of a market devoid of stability. What was a smooth ride for most of 2018 is no longer the case. In my view, fear of inflation and rising bond yields is at the root of the volatility. Of all the underlying factors considered, rising costs deserves the most attention – a frequent talking point in one quarterly earnings transcript after another.

After unsettling dips in 2015 and 2017, inflation appears on an upward trend, with pressures mounting. Strong government spending is expected to continue through most of next year, the U.S. consumer is healthy – with household debt-to-disposable-income at its lowest since 2001 – and the labor market is expected to tighten further as noted in the latest round of jobs data.

The oversold rally seen this past week was inspired by the S&P 500 finding key support at the 2,600-level coupled with some strong earnings reports, some dovish comments by two Fed presidents, hints of fresh dialogue between the U.S. and China, and a midterm election resulting in what the market had hoped for – gridlock in Washington. I doubt very many investors expected a 200-point rally for the S&P to ensue over seven trading days, but the bulls have retaken the high ground – at least for now. And yet from the chart below of the SPDR ETF (SPY), the index is butting up against a level that could spark short-term profit taking followed by some consolidation.

BesidePresident Trump’s berating Fed President Jerome Powell and most of Wall Street that the Fed Policy was moving too tightand too fast, the economic calendar delivered a stunning employment report that immediately capped the outspoken criticism. The influential Employment Situation report for October, showed nonfarm payrolls increase of 250,000, higher than the consensus of 188,000 while average hourly earnings increased 0.2%, and the unemployment rate remained at 3.7%.

In short, the strong jobs report validated labor market trends that will keep the Federal Reserve on a tightening path. The Fed-sensitive 2-yr yield and benchmark 10-yr yield spiked seven basis points each to 2.96% and 3.222%, respectively, compared to 2.81% and 3.08% yields last week. The long bond 30-yr Treasury yield jumped to 3.45%. Also, the U.S. Dollar Index added 0.2% to 96.48.

So, as the glamour of earnings season closes out, investors will digest the midterm elections and the policy statement that will follow this week’s FOMC meeting. While little attention was given the to the bond market last week, I believe it will be the major focus of interest in the days and weeks ahead. The data supports bond yields risk rising further and while investor sentiment has transitioned into accepting the recent rate hike and new higher levels for bond yields, a further bump in yields creates headwinds.

Tax reform continues to fuel corporate and consumer spending and will, in my view, sustain the economy and extend the rally longer than the current consensus expects as long as the cost to borrow and finance doesn’t push too much on the string of business and consumer budgets. The higher cost of borrowing is acceptable as long as sales and income are benefiting at a faster pace. This is the transitional perception that will likely become the center of the narrative and only the economic calendar will determine how that perception takes shape.

The midterm elections and the resignation of U.S. Attorney General Thirty-three states and the District of Columbia currently have passed laws broadly legalizing marijuana in some form. As of this past Wednesday, the District of Columbia and 10 states — Alaska, California, Colorado, Maine, Massachusetts, Michigan, Nevada, Oregon, Vermont, and Washington — have adopted the most expensive laws legalizing marijuana for recreational use.

Most recently, Michigan voters approved a ballot measure permitting adults age 21 and over to purchase and possess recreational-use marijuana. Some other state laws similarly decriminalized marijuana but did not initially legalize retail sales.

Most other states allow for a limited use of medical marijuana under certain circumstances. Other states have passed narrow laws allowing residents to possess cannabis only if they suffer from select medical illnesses. A number of states have also decriminalized the possession of small amounts of marijuana. Whatever the level of legalization, the wind is to the back of the pot trend with a few stocks now listed in the U.S. that will soon number many.

While most of the popular pot stocks soared on the news of more states legalizing along with the resignation of Jeff Sessions, the sector is very fickle in how it trades. Wednesday’s big gains were met with fierce profit taking yesterday, making for a very difficult trading environment and are why having the power of AI in your trading toolbox about as essential as the air we breathe if one is going to invest in pot stocks.

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