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Short-sellers piling into Canopy Growth and other marijuana stocks

Marijuana plants stand in a room at the grow facility for Sense of Healing dispensary in Denver, Colorado, U.S., on Wednesday, Dec. 9, 2015.

Matthew Staver/Bloomberg

Cannabis stocks have shot upward, led by industry leader Canopy Growth Corp.'s gains of 60 per cent this month and 337 per cent over the past 12 months. The trigger, for the most part, was recent voting in several U.S. states legalizing marijuana and Prime Minister Justin Trudeau's 2015 election pledge to legalize pot. But short-sellers' bets are also skyrocketing, suggesting the run-up in stocks has gone too far too fast.

Data from TSX Datalinx show a jump to 4.3 million shares from 2.5 million shares sold short during in the two weeks ended Nov. 15.

This was large enough to put Canopy Growth on the list of 20 companies with the largest net increases in short position. Back on Sept. 30, the short position was a mere 102,000 shares. Comparing the recent short interest of 4.3 million with this base yields an increase greater than 4,000 per cent.

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There is a bit of déjà vu going on here. In 2014, some other U.S. states legalized marijuana use, unleashing a mania for marijuana stocks in that country. For example, shares in General Cannabis Corp. soared from $5 (U.S.) to a peak of $50 during the first three months of 2014. Thereafter, however, the price trended down. By the end of 2014, it had fallen below $5. Now trading over the counter in the United States, General Cannabis stock is currently enjoying a rebound of sorts thanks to the recent uptick in enthusiasm: The price has climbed to nearly $4 as of mid-November from $1 in early September.

That's not to say the current rally will suffer a reversal of similar magnitude. A major difference this time around is the greater number of jurisdictions that are opening up to recreational and medicinal use. Marijuana companies such as Canopy Growth are also considered more substantial than the ones around in 2014.

Nonetheless, there could be periods of selling pressures. Valuations are not only stretched but there is a likelihood that marijuana companies will soon capitalize on their soaring stocks by issuing secondary rounds of equity.

Nearly all are in a position of negative to low cash flow, so it will be hard to resist an opportunity to raise more money. But this will dilute shareholder equity; the greater supply of shares trading on the market could be a weight on stock values.

The recent experience of shareholders in shipping companies is an illustration of what can happen. Companies operating cargo-carrying ocean vessels had a massive rally earlier in November.

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DryShips Inc., for example, shot up to $100 from $5 on the Nasdaq in less than two weeks. But then it announced a secondary offering of shares and the shares quickly retreated over the following days.

Shares in leading marijuana companies such as Canopy Growth could very well turn out to be good long-term investments. However, there may be periods of excessive optimism that result in a retracement in price.

Indeed, there has been a retreat in recent days – but the question remains: How much further will the pullback go, and will it return after a counter-rally or two?

Larry MacDonald is an economist, author and financial writer. Visit his website.

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