When a stock goes “parabolic,” the trajectory becomes so steep so fast that the chart starts to look like the right side of a parabola.
A parabolic price increase also bears resemblance to a rocket ship taking off. The analogy makes sense in more ways than one. Consider how a rocket behaves:
- To escape the gravity of earth, a rocket must travel almost straight up with tremendous force.
- If it escapes gravity, the rocket leaves the atmosphere and travels to outer space.
- If it does not, the rocket falls violently back to earth.
Parabolic stock moves follow a similar logic.
For example, not every parabolic move results in a “falling back to earth” — sometimes the stock reaches a new level and stays there. For this to happen, the valuation prospects for the underlying company have to radically change.
Say, for example, a tiny biotech company gets a major drug approved by the FDA. On that kind of development, the company’s market cap might go from $50 million to $1 billion and stay there.
In analogy terms, this would be like the rocket reaching space or making it to another planet.
If gravity wins out, however, the parabolic move is reversed, and the stock sees a giant crash. This is akin to the rocket falling back to earth.
In recent days, Tesla Inc.’s stock (TSLA) has gone full-on parabolic. This is a thrilling development for long-time Tesla bulls, a nightmare for bears, and a danger zone for anyone involved.
You can see the parabolic pattern in the Tesla chart below. To give perspective on how extreme this move is, TSLA stock was recently more overbought than Bitcoin on its way to $20,000 in 2017.
A parabolic move is dangerous to bulls and bears alike, but for different reasons on either side. First, we’ll look at some bull-side dangers, and then some bearish ones.
In a parabolic move, one of the biggest bull-side risks is assuming the move will keep going. Investors have lost gargantuan sums plunging into markets at the worst time. A parabolic move can invite this behavior because of intense Fear of Missing Out, or FOMO.
It is how Isaac Newton lost his fortune in the South Sea bubble of 1720: Newton took a modest position in South Sea Company stock; cashed out for a profit; sat on the sidelines as the market kept rising; then jumped back in with a huge position after a parabolic move, just in time to get wiped out.
It isn’t guaranteed that a parabolic stock will fall back to earth, implying a decline of 50 to 75% or even more; it’s just a real possibility that needs to be accounted for.
Tesla is benefiting from a major surge of bullish sentiment after turning in a string of impressive quarterly results, but TSLA is also benefiting from one of the biggest “short squeeze” episodes in history, as Tesla has long been one of the most heavily shorted stocks in the entire market.
The possibility of TSLA benefiting from a short squeeze, if not the mother of all short squeezes as hedge fund managers get killed, speaks to another bull-side risk: Assuming that a parabolic stock move automatically means thesis validation.
Diehard Tesla investors sitting on big profits now may be triple or quadruple convinced that they were right all along, and that Elon Musk is going to globally dominate the electric vehicle (EV) market.
This may or may not be true, but a parabolic move does not settle the case either way; it just speaks to the huge amount of bullish sentiment (and short-covering) currently in the market.
From a neutral observer point of view — neither bullish nor bearish — the ultimate test for Tesla comes down to technology, scale of production, and market dominance.
Whether the TSLA move is justified really depends on three questions, none of which can be answered by a balance sheet:
- Does Tesla have a technology edge over all other automakers?
- Can Tesla scale its production to match the volume of other car makers?
- Is Tesla so far ahead in EVs that the brand can dominate with no challengers?
It’s possible the answer is “yes” to all three questions — and that is more or less what Tesla bulls believe.
If Tesla has a technology and innovation edge that cannot be replicated by competitors; an ability to scale rapidly and efficiently to significantly larger production volume; and a brand so dominant it will never be seriously challenged in the EV space; then yes, it is theoretically possible that Tesla deserves a $100 billion-plus valuation based on blue-sky potential alone.
If any of those questions come out as a “no,” however, there is no way to sustain Tesla’s $100 billion-plus market cap (which, at the time of this writing, is 58% more than Ford and General Motors combined).
This brings us to the bear-side risks of Tesla, which come down to a few basic rules:
- Don’t short a company with a great product.
- Don’t short cult stocks.
- Don’t assume the balance sheet matters.
- Don’t short a bullish chart.
- Don’t short a stock going parabolic.
There are exceptions to the first four guidelines, but only under very special circumstances. There is no exception to the fifth rule.
If a company has a great product — with “great” defined by its fan base, not personal taste — that company will also have a built-in audience to support the stock.
If a stock is a “cult stock” — meaning the company, the leader, or both are seen as genius, world-changing, and visionary — that makes it even more dangerous to short. A recent news story profiled a true believer with a Tesla tattoo on his arm. At the same time, saying even a hint of something bearish about Tesla in a public forum is an open invitation to get attacked. That’s a cult attack.
Shorting based on the balance sheet alone is another bearish error. For a long time, Tesla’s balance sheet looked so bad, many wondered how the company would survive. Adding insult to the bear case, some of the accounting practices looked questionable and multiple CFOs and other top executives have passed through Tesla like a revolving door.
In the face of a compelling story, though, none of the balance sheet stuff has to matter. It might make a difference at some point down the road, but as long as the bullish story is plausible, optimists can ignore the accounting and valuation issues.
Then, too, a lot of bear-side issues are cleared up by refusing to short a bullish chart.
If the stock is strong enough to break overhead resistance levels, and has established new highs and a recent uptrend, then bullish sentiment could be far stronger than expected; or there could be hidden pieces of information the bears are missing; or any number of other things.
The last guideline, “don’t short a stock going parabolic,” should never be broken under any circumstance. That is because, when a stock goes parabolic, there is literally no telling where it finishes up. Maybe it comes back to earth; maybe it goes to the moon.
On a related note, Tesla also behaves like a speculative bellwether. That is to say, the level of bullish engagement and positive sentiment around Tesla says something about speculative appetite for stocks in general.
From that perspective, Tesla going parabolic suggests that “melt-up” conditions could spread to other parts of the market. And in fact, that is exactly what Dr. Steve Sjuggerud expects to happen this year. On Feb. 12, he will premiere the latest on his “melt-up” thesis in a special webinar. Go here to sign up or get details.
TradeSmith Research Team