Undy: You must drill the thermostat to allow water to circulate slowly as the engine is warming up. This way the coolant is warming evenly as is the engine. Otherwise the engine will have very hot spots and flash into steam while others areas will be cold. That's the reason for the bypass in the first place. You're seeing spikes in engine temps because the localized steam expands and blows open the thermostat. When the superheated coolant then passes the thermostat and the water-temp sender, you see a spike in engine temperatures followed by a rapid cooling.
See ERA's instructions on drilling a thermostat and how to position it in the housing:
Thermostat modifications