Aurora Cannabis (ACB -2.56%) shareholders are probably on Cloud Nine after shares of the Canadian cannabis producer skyrocketed more than 50% on Friday and were up 94% at one point. The U.S. election results have investors more excited about Aurora than they've been in a very long time.
Are the good times ready to roll again for Aurora Cannabis? Don't bet the farm on it. Here's why Aurora's ginormous gain could quickly evaporate.
Anatomy of a short squeeze?
Around 19% of Aurora's outstanding shares were sold short as of Oct. 15. When there's good news for a stock that's so heavily shorted, short-sellers usually scramble to cover their positions. This creates significant upward pressure on the share price, resulting in what's called a short squeeze. It really looks like we're seeing a short squeeze with Aurora Cannabis stock right now.
Of course, there are also investors who aren't short-sellers and are now more bullish about Aurora's prospects. Their buying only makes it harder for short-sellers to maintain their positions.
The important thing to know is that most short squeezes inevitably collapse. Sooner or later, all of the short positions are covered. When that happens, the artificially driven momentum ends almost immediately.
How long can a short squeeze go on? It depends. But if the good news that spurred short-sellers to run for the hills in the first place becomes not-so-good, the party could be over quickly.
Everything hinges on the Senate
With that in mind, let's look at the good news serving as a catalyst for the upswing in Aurora's shares -- the U.S. elections. Many marijuana stocks rose on the prospects that Joe Biden would win the presidential race and that Democrats have a chance at gaining control of both houses in the U.S. Congress.
Investors are hoping that a Democratic sweep would greatly increase the possibility of federal marijuana legalization, even if only for medical cannabis, along with federal recognition of states' authority in enforcing their own recreational marijuana laws. This would be great for Aurora, since it would pave the way for the company to expand into the lucrative U.S. marijuana market.
But the news isn't as positive as many investors might think. Most importantly, the path for Democrats to regain control of the U.S. Senate isn't an easy one. At this point, it seems likely that runoff elections in Georgia will decide which party claims a majority in the Senate.
Expect a fierce battle in Georgia, with Republicans arguing that voters should keep the Senate in GOP control to provide a balance against a Democratic majority in the House and a Democratic president. If Georgians ultimately vote for the GOP candidates, Sen. Mitch McConnell (R-Ky.) is likely to retain his position as Senate majority leader. McConnell could singlehandedly prevent any bills related to cannabis reform from being voted on in the Senate.
What will happen with Aurora Cannabis stock? My prediction is that most of its gains from last week will soon go up in smoke. The short squeeze will end. The political reality of the battle ahead for control of the Senate will sink in. And shares of Aurora will sink like a brick.
Don't get me wrong: I'm not dismissing the Democrats' prospects of winning a Senate majority (or at least a 50-50 split that would effectively give the party control, since the vice president casts any tie-breaking votes). However, the runoff elections in Georgia won't be held until January. That's a long time for investors to begin to worry again about Aurora.
I'm also not saying that Aurora won't be able to make another significant comeback. If the company achieves its goal of generating positive earnings before interest, taxes, depreciation, and amortization (EBITDA) in its next quarter, investors' enthusiasm for the stock could rise.
For now, though, my view is that Aurora's tremendous returns will be short-lived. Irrational exuberance usually doesn't end well.