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Is This the Real Reason Behind the Marijuana Stock Surge in 2019?

By Dan Caplinger - Updated Apr 22, 2019 at 10:40PM

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A common trend might have boosted the cannabis sector to start the new year.

Marijuana stocks are off to a fast start in 2019, giving many cannabis investors some relief after what had been a tough year in 2018. Despite all the progress that cannabis companies made from a fundamental business perspective, share prices didn't follow suit, and many of the best-known businesses in the marijuana industry had to deal with substantial negative returns for the year. Big gains in January for the biggest players in the industry, as well as ETFs, such as ETFMG Alternative Harvest ( MJ 0.71% ), that own many top stocks in the business, are reassuring for those who got burned in the late-2018 slump.

Many investors who've been inspired to invest in cannabis companies aren't necessarily familiar with the factors that influence stock investing more broadly. But investors with more experience have often seen patterns like the one that marijuana stocks have followed lately, and there's a possible cause that could explain exactly why the share prices of many cannabis companies have taken that particular path: late-year tax-loss selling followed by subsequent buying to start 2019.

Rows of cannabis plants in an indoor greenhouse with lights overhead.

Image source: Getty Images.

A different kind of harvest for cannabis investors

No one likes to lose money on an investment, but investors frequently try to take advantage of a silver lining available when they've picked a losing stock. The strategy known as tax-loss harvesting involves selling off a stock that's gone down in value since you bought it. Doing so allows you to claim a capital loss on the difference between what you paid and what you received from the sale. If you sell before Dec. 31, then you get to claim that loss on your tax return for that year.

However, there's a catch to using the tax-loss harvesting strategy. If you decide to sell a stock and claim a capital loss, then you're not allowed to buy it back during the 30 days after the sale. That prevents investors who want to stay invested in a stock for the long run from just doing a quick sale to get the tax loss and then immediately buying back the shares. You're also not allowed to try to get around this restriction by buying additional shares immediately before you sell your earlier-purchased stock, as the prohibition also applies to the 30 days before the sale.

Why tax-loss harvesting can affect share prices

There's no requirement that tax-loss harvesting be done late in the year, and there are real advantages to doing it earlier. Yet because most people don't start thinking about taxes until the last possible moment, December is the most popular time for investors to use the strategy.

Institutional investors are well aware of the desire among investors to take tax losses. So what you'll often see with beaten-down stocks is that losses get worse going into December, as last-minute tax-loss sellers are willing to accept any price they can get to dump their shares and get their tax break.

When January begins, all that tax-loss selling pressure disappears. Moreover, some investors want to start getting back into the stock as soon as the 30-day restriction has passed. Institutional investors know this too, so they hold out for higher prices before selling shares to would-be stock buyers. That tends to send shares upward -- exactly as we're seeing at the start of 2019.

Think twice before you sell

This phenomenon shows one of the dangers of tax-loss selling, showing that it isn't always the best move. If you've truly given up on the prospects for a losing stock that you own, then selling it makes plenty of sense. But if you still think that a company has long-term promise and is merely going through a rough patch, then a short-term sale just to cash in on a tax loss risks missing out on a big recovery during the 30 days that you're not allowed to buy back in.

For marijuana stocks, there are a couple of implications from the tax-loss-sale phenomenon. First, some gains at the beginning of the year might be somewhat artificial, reversing similarly artificial exaggerated losses to end 2018. That's just noise from a long-term investor's perspective, but it will color the way that the entire cannabis industry gets covered in 2019 if the gains hold.

Second, it'll be important to watch how cannabis stocks behave after investor-buyback activity slows. If marijuana stocks give back their gains, then it'll be a warning sign that the sector could have gotten too far ahead of itself -- at least in the short run.

Gains for marijuana stocks have pumped new energy into the cannabis industry, and it'll be interesting to see how the sector continues to evolve in 2019. Share prices can move for a variety of reasons over short periods of time, but eventually, cannabis companies will have to show fundamental business success in order for their stock prices to keep rising.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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