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The recent legislation on both the state and federal levels regarding the legalization of marijuana has caused many of the stocks in this space to significantly increase in value over the last few months. Many would argue that these stocks are overpriced because there are issues with management, limited prospects for growth or for whatever reason. Some investors have seen these conditions as an opportunity to short the stocks in this sector. But successfully shorting a stock requires both good timing and the ability to correctly predict the issues decline. When these conditions are not properly managed, the person or entity shorting the stock (known as "Shorts") can find themselves exposed to what's known as a "Short Squeeze" when trying to cover their positions. This can be an opportunity for investors who have favorable perspectives for the stocks.

First, some of the basics; shorting a stock involves borrowing securities and then selling them with the expectation that the securities can be purchased at lower prices than what will be paid to replace the borrowed securities. But if the securities go above the Shorts' purchase price, the Short takes a loss of the difference between the purchase price (they were paid) and the higher securities' purchase price they will have to pay to close the transaction. In theory, Shorts are said to be exposed to unlimited losses because there is no fixed limit to what someone could pay for a stock. Of course we know there is a logical limit, but the point is that the stock could rise to create significant losses for a short position.

This is where the short squeeze comes in. When the Shorts are trying to purchase stock to replace the securities that were borrowed and sold, the increase in buying could cause a sharp increase in demand for the stock that is above the lower price points and thus "squeeze" the price up. To manage some of the risk associated with short positions, some entities write or commission "Hit Pieces." Hit pieces are articles that are meant to mislead, confuse and scare investors into selling stock and thereby causing the price to decline because of the selling pressure. These types of articles could be in violation of SEC Rule 10b-5 Employment of Manipulative and Deceptive Practices, which states:

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So those employing those types of tactics often have to tread very carefully. But ultimately it will be the true value of a security that prevails. Not all articles that are negative towards a stock are hit pieces. Many offer alternative perspectives that are valuable in helping shareholders and potential investors make future investment decisions.

For this article we will be looking at the following companies and reviewing their current short exposure:

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The short interest for each stock can be viewed using the links in the bulleted list above Table 1, but are also summarized in the table for quick reference. As you can see, Feb 15th showed significant short interest increases for the stocks with MJNA's spiking over 6000% alone. PHOT was a little less than half with its short interest of 1500%+. MJNA's increase in short sales was likely associated with the release of Infitialis's article "Chronically Criminal" in which they stated that Medical Marijuana "is a penny stock company run by criminals and alleged fraudsters." The article was actually released on the 15th of February, which lined up perfectly with the date of the short interest reporting. As for the overall effect, a lot of these stocks trade in lock-step, so the other marijuana stocks in this space were also most likely affected by the article's focus.

For the most part, the stocks in the space that had an initial increase in short interest have since stabilized. The year-to-date (YTD) time frame in Chart 1 below shows that the biggest change occurring around the same Feb 15th date, with little change occurring thereafter. Again, the big spike for MJNA is very evident. (click to enlarge)

Chart 2 below shows the number of shares shorted for the year, which dramatically increased during the second half of February, only slightly declining during the first half of March. So, as you can see, most of the short positions are still open.

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With the stock prices somewhat stabilizing as shown in Chart 3 below, a positive catalyst could very quickly cause these stocks to rise to produce a short squeeze if that catalyst is realized.

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A short squeeze by itself will not be enough to sustain a prolonged increase in share prices in any stock mentioned here because most of the positions would only take a day to cover at the current volume levels. Also, these positions are relatively small when compared to the size of the public floats of the issues as shown in Table 2. So again the short squeeze would not have a prolonged effect.

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But I do think that the initial pop could set up a decent floor for future gains, which could provide longs with a nice cushion moving forward. So what kind of catalyst could we expect?

The Holder Effect

Both the advocates and opponents of marijuana legalization are waiting to see what US Attorney General Eric Holder will do regarding Washington and Colorado's new laws legalizing marijuana for recreational use. While the Department of Justice [DOJ] has previously tolerated state legalization of medicinal marijuana, the new policy changes could affect medicinal use as well. Holder's actions will be the beginnings of wider reforms that will set the tone for how investor's evaluate the risks associated with investing in marijuana businesses moving forward.

One can only speculate at this point as to what Holder will do, but there are indications of how this issue can be rationalized and eventually unfold. If Holder had already made up his mind to fight the states, I think there would have been much more rhetoric coming out of the Obama administration on the subject. Here is how I think Holder will approach the issue.

I believe that Holder will further soften on medical marijuana enforcement. I say this because of the growing legislation being introduced in the various states and support being vocalized by elected officials. For example, Maryland's House of Delegates recently approved HB 1101 with a 108 to 28 vote to approve the bill. The bill has since moved to the state Senate where it passed the second reading of the bill. The bill can now move for the final reading and vote before moving on to the state's governor, Martin O'Malley for approval.

Gov. O'Malley had previously objected to medical marijuana being dispensed within the state, but changed his position after noting that his previous concern that state employees could be at risk of federal prosecution did not materialize for other states. Gov. O'Malley favors HB 1101 because it provides for academic medical centers to run the compassionate use programs. Senate Bill 580, which establishes an affirmative defense for possession for medical use and specific drug paraphernalia also passed the state Senate and the state House of delegate on 2 Apr 2013 and now goes to Gov O'Malley for signature.

Ever heard of Johns Hopkins School of Medicine? Johns Hopkins School of Medicine was founded in 1893 and is located in Baltimore, MD, which is about an hour's drive to the U.S. Capital in Washington, DC. My guess is that, with their prestigious position in the medical community they would be selected as participants in the pioneering program. Also, with their proximity to the District of Columbia, they would certainly lend a tremendous amount of creditability to support legalization at the federal level. This alone would support accelerating federal laws that would remove prohibition for medicinal applications.

But the 800 pound gorilla in the room is what Holder will do regarding recreational use. After having met with the governor's of Washington and Colorado states, he has advised that he will be offering the DOJ's official position "soon." The governors have characterized that the meeting with Holder was very productive. I believe that Holder's decision on not focusing on recreational use will rely on how well the states put in controls that prevent abuse by children and smuggling across state lines.

The Czar Effect

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Washington State has just chosen Botec Analysis Corp. to advise the state on how they will implement the transition to recreational legalization. The firm was founded and is currently led by UCLA Professor Mark Kleiman. His bio includes a reference to him authoring "Abuse, Costs of Control; of Against Excess: Drug Policy for Results."

His selection offers a tremendous amount of credibility to the development of a system of balanced control. In his CNN interview with Erin Burnett, he made his impartiality clear. The personal opinions of his employees and him are irrelevant and the recommendations made by his team will be accurate, regardless of how they view the merits of the recreational legalization initiatives. He was making the point that the decisions of his team might not be favorable or a rubber stamp to promote the state's initiatives. I think that this is the type of serious oversight Holder will be looking for.

Conclusion

Now considering all that, and the legislation that U. S. Representatives Earl Blumenauer representing Oregon's 3rd congressional district and Jared Polis representing Colorado's 2nd congressional district introduced, I think that there is plenty of catalyst ahead for the industry and the stocks mentioned.

Investing in micro cap stocks involves risk. Make sure you do your due diligence before investing in any issue. A short squeeze is a short-term effect that can prove to be very lucrative for investors, but are not indications of the longer-term value of the underlying securities. I think that all of the stocks used in this analysis have long-term prospects. I own all of them except MDBX, which I will contemplate once I feel that I have enough information to determine a good price point for entry.

Source: Marijuana Stocks Could Be Setting Up For A Nice Short Squeeze