How to use technical analysis to spot bubbles: GameStop

Back in the dot.com boom-and-bust I was about the same age as most of the current cohort of Robinhood traders. I made all the mistakes many millennials are probably making right now.

Each boom has a mantra. Back then it was, "this time it's different". That is, the idea that technology (and to a large degree at the time, the internet) was going to change the world so much that the exponential price rises demonstrated in stocks was justified. "Old world valuation concepts are redundant!" we said.

I'm no millennial, so I don't want to assume what the mantra is this time, but perhaps it's the "democratisation of investing". This means getting a piece of the action previously only available to a privileged few Wall St Fat Cats. Perhaps, it's also a bit of an up-yours to the establishment!

Either way (1999-2000 dot.com boom, or Robinhood/Reddit WallStBets craze), it's likely to end in the same way. A great deal of pain for those who thought they had worked the system out, but then woke up one day to realise they hadn't (sans a great deal of their capital).

GameStop (NYSE: GME) has inspired, and in many ways, defined this movement. The tail wagging the dog...the underdog biting back...David vs Goliath...whatever you want to call it. But setting aside the rhetoric, hype, and hysteria, as a case study in price and volume - it is absolutely fascinating!

I have a tried-and-true methodology for how to identify when bubbles are about to burst, developed over more than two decades of watching the markets. It's based upon the theory that the same old mistakes will continue to be made, but by new investors, for many GameStops to come.

So, what does a "normal" bubble look like? Let's start by defining a stock price bubble. There's no fixed definition because each bubble is a little different, but typically, in a bubble, a stock's price rises a large amount in a short space of time. Often, the price appears to take on an "exponential" shape as it accelerates upwards at an increasing rate.

Given the fragile beauty of a bubble, it must eventually burst. So, on the other side of the massive price rise is (generally) an even steeper decent. Often, a few weeks or months after the bubble, the stock's price has returned to where it was trading before the bubble.

It would appear from the above definition that bubbles should be pretty easy to spot on a chart, and indeed, after the fact they do tend to stand out like you-know-whats! The problem is however, when one is in the bubble, the rhetoric, hype, and towards the end, hysteria, can often cloud investors' collective judgements. It takes a wise and experienced hand to spot a bubble, and if one chooses, to participate on the way up but then know when to jump ship before the inevitable crash.
 

Technical analysis (or "Charting") is the study of how a stock's price changes over time. Technical analysts use the price action from a stock's chart, and various indicators, to draw conclusions about the actions and intentions of market participants. The aim is to make educated guesses about future price moves.

When using at a stock's chart to assess the prevalence of a bubble, the first thing to look out for is exponential price movement. The price movement will generally be accompanied by similarly increasing volume (that is, how much stock has changed hands each trading session). Also, the price movement will be accompanied by increasing volatility, that is, the range over which the stock's price traded for the trading session.

As long as the price, volume and volatility are expanding steadily, there is a higher probability that the trend may continue. If the price of the stock reverses sharply, especially when the close of the session is well below the high of the session, watch out! If such a price move is accompanied by a big volume and volatility spike, it's probably time to get out.

This is because together, these indicators are symptomatic of a "blow-off top". This pattern is created by insiders who were probably in very early in the run-up, selling to late comers who are now holding the stock at elevated levels. Without the continued support of the insiders, and with only hot money still holding (now vulnerable to losses because of their late entry), prices can fall quickly.

After the price, volume and volatility signal, the last straw typically comes when volume and volatility begin to contract - often sharply. This is symptomatic of once frenzied buyers holding back on their purchases, and anxious holders scrambling to lock in shrinking profits, or stave off deeper losses. Some professional traders may even go short, contributing to an environment of decreased demand and increased supply. Prices can really tumble from here.
 

Let's use GameStop as a case study for our bubble analysis. Looking at the chart below, it certainly appears to have all of the hallmarks of a bubble, including a meteoric rise, followed by an even more spectacular fall. 



The price is at the top of the chart. I deliberately used Japanese Candlesticks to depict the price action. The white candles indicate price rises, and the black candles declines. The line sticking out of the top and bottom of each candle (called a "shadow") represents where the price travelled outside of the open and close of the session. One can consider an upward shadow as measuring the degree of supply in the market, and a downward shadow as measuring the degree of demand in the market.

The red arrow points to where the key bearish price action signal occurred. Remember, this is a close well below the high of the session. This is the point where investors should switch to extreme caution. If the price cannot get back above the high of this signal candle, and if other bearish candles are observed immediately afterwards, there is a very high probability the bubble could be about to burst.

Note also, the blue columns which represent the stock's volume for each session, and the red columns which represent the price range which the stock traded (including any gaps - called the Average True Range (ATR)). One can clearly see the tell-tale signs of increasing volume and volatility into the bearish price action signal.

The clincher (and popping of the bubble) came after the dramatic fall in volume and volatility after the bearish price action signal. This was exacerbated by restrictions placed on the trading of GameStop shares at a number of free brokerages like Robinhood. Without the hot air in the form of demand to keep the GameStop bubble inflating, the pop was inevitable.
 

GameStop is now well on the way to becoming a footnote in the history of the markets. If past bubbles are anything to go by, the noise around the stock will die down soon enough, as will its price. Also, if the past is anything to go by, it is unlikely to ever see its high of $483 again.

Hopefully, you didn't get caught up in the bursting of the GameStop bubble. Also, I hope that this guide equips you with the tools to spot the next one and to profit from it. If you did get caught in the GameStop bubble, rest assured you're not the first, and certainly won't be the last. There's an old saying in the markets that should inspire you to increase your level education when it comes to investing and learn from your mistakes: "Don't get bitter, get better!"

Also read: Could GameStop stop the bull market?