Pot Stocks: How To Spot Tops

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Includes: ACB, APHA
by: Taylor Dart
Summary

Since the Marijuana Stocks ETF on the Canadian Market peaked in early 2018, the ETF is down nearly 40% as of this week's lows, with some pot stocks down 70%.

No matter what the asset class, tops all occur in very similar ways.

This article serves as a case study of how to spot tops ahead of time so that traders/investors don't get caught riding the trend back down.

One of the most popular phrases thrown around by traders and investors is that "this time it's different", and as John Templeton taught us, these are the four most expensive words in the English language. In December we heard from all of the Bitcoin aficionados that the currency was nowhere near topping, with one author even suggesting a price target of $142,000. In January we saw the exact same thing happen with the pot stocks investors, despite them having front-row seats to the disastrous dive in Bitcoin and other cryptocurrencies. In both cases, investors/traders in the asset classes told us that "this was the last chance to get in", "this time was clearly different", and those not in were foolish for being on the sidelines. I think what some fail to realize about markets and asset classes is that this time is never different. Markets move based on human emotion and human emotions never change. While bubbles and crashes do not always have the same duration and the same rates of ascent or decline, they share very similar characteristics that I will share in this article.

Mark Douglas discusses this further in the below quote.

"A finite number of traders participate in the markets on any given day, week, or month. Individuals develop behavior patterns and a group of individuals interacting with one another on a consistent basis form collective behavior patterns that are observable and quantifiable, and these patterns repeat themselves with statistical reliability. Technical analysis organizes this collective behavior into identifiable patterns that can give a clear indication of where there's a higher probability of one thing happening over another. In a sense, technical analysis allows you to get in the "mind of the market" to anticipate what's likely to happen next based on the kind of patterns the market generates at some previous moment. It keeps the trader focused on what the market is doing now in related to what has happened in the past, instead of focusing on what the market "should" be doing based on what is 'logical' or 'reasonable'."

It's important to note that technical analysis is not perfect, it simply gives odds. There is no holy grail. Like no hand works everytime in poker, not every trade works in trading, but if you play the better starting hands consistently with the best probability of working and the best risk/reward, over time you will have an edge.

Last year, we saw the price of Bitcoin rise well over 1000% in 12 months as speculators flocked into the currency for several different reasons. Some of which were the supposed safe haven of the currency vs. other world currencies, and other reasons ranging from lack of supply due to it being costlier to mine to supposed supply limits. While all of these reasons may be valid, parabolic rises often price in all of the rosy fundamentals during ascents of this magnitude. This is what I think some speculators failed to realize that were buying in late Q4.

The pot stocks had their own reasons for going higher, but the investment appetite for them has dampened a little due to concerns over delays to the legalization of recreational use, as well as stricter distribution rules. While these concerns may be overinflated, the fact is that the stocks were priced for perfection in December and January. In early January at the peak the top 10 Canadian pot stocks were valued at over $20 billion, but it was estimated that Canadian demand for cannabis in 2017 was less than $6 billion. Either the demand numbers are grossly wrong, or the market capitalizations of the main pot names were getting a little frothy. Aphria (APHQF) for example recorded net income of $15 million for fiscal Q1 2018 but boasted a market capitalization at its peak of $4.8 billion. This resulted in the company trading at a P/E multiple of 320. While these multiples are reserved for the best growth companies, this was becoming a bit of a generous multiple pre-legalization.

(Source: TC2000.com)

(Source: TradingView.com)

(Source: TC2000.com)

The two most obvious things one can watch for to warn of impending tops are extreme bullish sentiment (especially from inexperienced and novice traders), and an unsustainable rate of ascent that suddenly changes its character. Both Bitcoin (OTCQX:GBTC) and the pot stocks (APHQF) both had these exact same characteristics, and I will show exact examples below to hopefully help investors/traders in future situations. While buying at a great price during a powerful bull move certainly helps, it's of no use if one does not have any plan on how or when to sell. Some readers may be thinking right now "how is this helpful at all in hindsight"? The comments I will show you below are literally carbon-copies of the comments and statements I saw made in 2011 with the junior mining stocks, with Intertainment Media (OTC:ITMTF) when it rose 2500% in 4 months in 2011, with Bitcoin in late 2017, and once again like clockwork with the pot stocks in late 2017 and early 2018. While there are not always sentiment indexes that one can track sentiment with on certain stocks or some asset classes, investor sentiment based on comments and statements can be an extremely valuable tool. I am not suggesting that one can trade solely off of these comments, but these comments provide a temperature reading for which stage one is in during a trend, and whether to be on high alert for reversal signals technically.

Sentiment

(Source: Twitter.com)

The above comment that "more money is going to flow into the space" is one I find we see near all major tops, especially if the technicals show we are late in the trend. With Bitcoin, the suggestion was that futures trading was going to open Bitcoin up to a whole new set of buyers that couldn't previously buy. Interestingly enough the launch to the futures market for Bitcoin was actually within a week of the top.

(Source: Twitter.com)

This is one I'll admit I've never seen before, but the fact that one would suggest that buying an asset class is a "get out of jail free card" under the premise that the bet cannot lose money is a massive red flag.

(Source: TC2000.com, Twitter.com)

The above comment "the greatest bull market of our generation", "the rarest form of market" is laughable and is basically another way of saying that the asset class is a new paradigm and "this time it's different" as it can't be compared to any other past bull markets. These are the types of things you usually see at or very close to tops. This post was made within one day of the top on the majority of the pot stocks. The key is not to simply get out when you do see these posts, but to look at where you are in the trend to get a good idea of if the extreme sentiment is also matching extreme parabolics in the technicals.


(Source: TC2000.com, Twitter.com)
(Source: TC2000.com, Author's Photo)

The above chart shows the mania phase of asset classes using emotions to dictate where one is in the cycle. It's amazing how similar the run-up is in terms of the two charts, and the "New Paradigm", and "Delusion" part of the chart is where you will typically see ridiculous comments and sentiment. For Bitcoin, this was suggestions of a $142,000 price target only two weeks before it topped, for pot stocks it was a suggestion that this would be the greatest bull market of our generation and is the "rarest form of market". By having an idea of what the average investor is saying, and by having this Emotion Chart saved for future reference, one can map out when a stock or asset starts to go crazy, and have a decent idea where they are.

This is why I find Twitter (TWTR) to be such a valuable tool as well as the comments sections of some stock forums. In a matter of only 10-15 minutes of work near inflection points, I am able to get a very good sample of sentiment to see if it is confirming the technicals.

So what if you don't want to use Twitter or aren't able to correctly identify a top based on sentiment alone? This is where paying attention to the technicals can be very helpful. Below is a look at how the marijuana stocks index topped, and a few different things you can look for. I was in Aphria (APHQF) on the Canadian Market from $6.44 CAD and got out of the last of my position at $17.27 CAD, updating my stops along the way on my Twitter account. Once I was made fun of for "selling early" by several different individuals and started receiving a barrage of private messages, I knew it was only a matter of time before they started to roll over.

Technicals

Taking a look at the below chart of HMMJ.TO, we can see that the index was up 165% in only 50 trading days, an extremely unsustainable trajectory for an index alone. While this may not seem that extreme and there have been more parabolic runs in the past, it's worth noting that many individual stocks like Aurora Cannabis (ACBFF) were up 450% over this same period. We can see from the October through early January period that there were five separate dips of 7% or larger on the index, and all of them proved to be great buying opportunities. Once a pattern of buying the dip like this becomes so obvious that it's exploitable by the average retail investor, usually, the pattern suddenly becomes unreliable. I pointed this out on my Twitter account on January 12th during the final successful dip as I felt that the pattern was becoming far too obvious. This was similar to the psychology aspect I was seeing on Twitter as traders were beating themselves up and turning into investors as every time they sold they were being punished by prices going higher. Whether the average investor/trader wants to admit it or not, there are some of them are more interested in being right than making money. This shift in sentiment combined with this being the 5th dip in less than 3 months that proved profitable told me that the easy money had been made, and the pattern was likely not going to be as successful going forward.

(Source: TC2000.com)

(Source: Twitter.com/TaylorDart01)

Using a more objective approach and purely moving averages, we can see that the Marijuana Stocks ETF trended up above its 20-day and 50-day moving averages for nearly four months in a parabolic fashion, with every dip being bought right near the 20-day moving average (white line). Once this pattern had occurred twice with successful dip-buys, the third time (once it became obvious) did not work nearly as well, and the price fell apart and sliced right through it after a one day bounce. This is because those that are keen on buying the dip will buy the dip the first time, those that are more experienced will pick up on this pattern immediately and buy the second dip to the same level, but once the third time occurs, even the average investor has picked up on the pattern. Once everyone sees it, there's a very small likelihood it's going to work as well as it has in the past.

(Source: TC2000.com)

Finally using another approach, we can see that the index was making similar highs and lows for months in early to mid-2016, but finally made a new high and substantially higher low (shown at the green box below), and this began a clear new uptrend. This pattern continued with higher highs and higher lows for a few months while price rose substantially, but this immediately changed for those that were watching closely in early 2018. Price made a low of $19.86 CAD on January 4th, but then made a lower swing low at $19.02 CAD after a new high was made. This meant that while a higher swing low was put in, a lower swing low was also put in, a sign of caution. Once price bounced off of this new lower swing low, it rose to the $24.32 level and made a lower high against the previous swing high of $25.56. This was the confirmation that the trend had changed. Not only had a lower swing low been put in, a lower swing high was also put in.

(Source: TC2000.com)

As I have been through these situations a few times before in individual stocks, I was out 15% before the top on the last leg of my Aphria position. I have no interest in catching the exact top or the exact bottom, I want the easy money, which many professional traders call "the meat in the middle". As Randy McKay (famous futures trader) accounts from one of his interviews:

"When the trade was easy, I wanted to be in and it wasn't, I wanted to be out. In fact, that is part of my general philosophy on trading, I want to catch the easy part - the meat of the move. The beginning of a price move is usually hard to trade because you're not sure whether you're right about the direction of the trend. The end is hard because people start taking profits and the market starts getting very choppy. The middle of the move is what I call the easy part. I never try to buy a bottom or sell a top, even if you manage to pick the bottom, the market can end up sitting there for years and tying up your capital."

(Source: TC2000.com)

(Source: Twitter.com)

(Source: TC2000.com)

I ended up selling 1/4 of my position at $7.75 CAD, 1/4 at $9.18 CAD, 1/4 at $10.67 CAD, and 1/4 at $17.27 CAD for an average selling price of $11.21. This netted a 74% gain on the trade in a span of 5 months. While I could have traded the stock a little better, I never beat myself up over taking profits early. My goal at the end of the day is to get at a low-risk entry price, and to make substantial profits on a trade. You don't need to be perfect, you don't need to catch lows, and you don't need to catch highs to be profitable in trading. You just need to find a low-risk entry point on a chart and be willing to sell when the story changes, whether technically or fundamentally.

I've received lots of questions in the past from investors and traders on this site about issues with selling as they are never sure if they are getting out at the right price. I don't see this as an issue. The right price to get out is at a profit, and ideally above your average profit based on your past 100 or even 1000 trades. If my average profit on a stock is 15% over the past 150 trades and I take a 75% profit, I'm not going to beat myself up if the stock goes up another 200% without me. At the end of the day if I know my average loser is only 4.5%, that one 75% profit just paid for 16 losing trades. I found that whenever I had to stay in a move because I wanted to be right and was scared to see it go up without me, I actually had much worse results. This is because when you are fixated on being right, you're not as focused on being objective. This leads to one making subjective decisions, having a cloudy mindset when the warning signs start piling up on the chart, and in many cases, looking the other way. This is why trading plans are so important as they don't let your emotions get caught up in a company or a trade, they tell you in big bold letters - the character of this stock is changing technically.

The biggest issue and downfall I have seen with the average investor is that they buy correct, they sit tight correctly, but they stay seated when they need to finally get up out of their seat. Below are a few things to watch for to avoid riding a trend up and then all the way back down as these things are often consistent with impending or confirmed tops.

  • When a market or stock rises in a parabolic fashion and is more than 100% above its 200-day moving average, pay attention to the character of an asset class vs. its 20-day moving average and 50-day moving average. Was it previously being bought at this moving average and now it's living below this moving average and not finding the same supportive action?
  • When you start hearing "new paradigm" type comments, "this is the last chance to get in", "there's no risk in buying here", or if you start getting made fun of for selling at what was a good profit, you're probably right to start taking profits if the chart is consistent with these comments and is in a parabolic uptrend.
  • If a market or stock moves into a parabolic fashion, pay attention to a new swing low, or a lower swing high showing up. In a parabolic uptrend, especially in a stock that's up 300% or more in a span of six months or less, a lower swing low and a lower swing high that are both confirmed are typically not a bad type to take some profits. When coupled with the ridiculous sentiment like we saw in Bitcoin and the pot stocks first-hand, you're probably much closer to the top than the bottom.

In summary, warning signs of a top are identifiable in many cases, and while you may not catch the exact top, getting out near the top or at least taking profits when things begin to get ridiculous is still a very profitable strategy. By waiting around for the exact top and by not knowing what to look for, often traders and investors get roped into the same crowd mentality as others and are unable to objectively look for these sell signals. Sentiment allows one to get a temperature reading of the market and to be on alert for sell signals (if, and only if) the chart is consistent with the overall sentiment of market participants. Technicals allow one to get confirmation of minor caution lights and red flags on an asset class, at a key inflection point where markets can turn very rapidly.

I hope some of these tools are helpful as I've found them to keep me out of trouble and allow me to play great defense when things do get too frothy. I will never buy perfectly and will never sell perfectly and I gave this up a long time ago, my goal is simply to buy as close to the "right" price as possible, and exit with a profit that is at least twice the size of my average loss over a large sample of trades. This guarantees that I will remain profitable in trading as long as I can maintain a 33% win-rate or higher.

Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.