The Right Market Environment For Big Stock Market Winners

The Importance of Market Environment in Stock Performance

Introduction

When it comes to stock trading, most investors are quick to focus on finding the right stocks. While stock selection is crucial, it’s only one piece of the puzzle. Equally important—and often overlooked—is the market environment in which those stocks are traded. The broader market environment can either magnify your returns or undermine even the best stock picks. A healthy market, with broad participation and rising trends, provides the backdrop for stocks to thrive. Conversely, even strong stocks struggle in a weak or declining market.

More precisely, it’s the environment where outsized stock moves occur en masse that really matters. This goes beyond simply studying when general indexes post a positive quarter or month. Investors must learn how to identify when the market environment is fertile ground for supporting 50%, 100%, or 300% stock advances in just a few months or quarters. As we’ll see, when the environment improves, stocks of all kinds make massive advances—not because the companies themselves suddenly transformed, but because the market is finally willing to pay dramatically higher prices and valuations.

Analyzing Market Health

Introduction to the Net Highs Net Lows Indicator

To gauge the market environment, traders use various tools and indicators. One particularly effective tool is the Net Highs Net Lows indicator. This indicator tracks the number of stocks making new 52-week highs versus those making new 52-week lows.

The premise and logic is simple: in a healthy bull market, more stocks will be hitting new highs, while in a weak or bearish market, new lows will dominate.

When more stocks are making new highs, it signals that investors are increasingly confident, which drives capital into the market. This broad participation is a reflection of investor psychology, where rising market confidence fuels a feedback loop of more investment and higher stock prices.

In addition, a 52-week high or low is a meaningful event. It demonstrates an investor willing to pay the highest or lowest price of that past year. That takes conviction, and when it occurs on a large scale, it identifies the net flow of capital.

Link to the Net High Lows Indicator in Trading View created by Caruso Insights

How to Interpret the Indicator

The key to the Net Highs Net Lows indicator is understanding the balance between these two measures as there will always be some stocks making 52 week highs and lows. When the market is healthy and in a growth phase, a greater number of stocks make new highs, reflecting broad participation. This signals that the market’s upward trend is supported by a wide range of stocks. In contrast, when new lows outnumber new highs, it indicates underlying weakness in the market, even if major indexes like the NASDAQ or S&P 500 may appear stable. Keep in mind that the most sensitive stocks will break higher or lower before the broad indexes, and this can often be an early indicator to trend changes.

Characteristics of Healthy Bull Markets

A healthy bull market isn’t just about rising indexes; it’s about broad participation across stocks. In robust bull markets, the Net Highs/Net Lows indicator shows a steady or increasing number of new highs, with occasional accelerations as more stocks reach new peaks. This widespread participation creates a solid foundation for sustained rallies, though most investors simply focus on the direction of indexes.

Case Study: The 2016-2018 Bull Market

Overview of Market Conditions

To better understand how market environments influence stock performance, let’s examine the 2016-2018 bull market. This period followed a volatile stretch from 2014 to mid-2016, where the market was largely sideways, with periods of both gains and pullbacks. Starting in late 2016, the market entered a more decisive and sustained bull run, which continued through to late 2018.

During the 2016-2018 bull market, the Net Highs Net Lows indicator showed clear signs of a healthy market. Starting in late 2016, there was a significant increase in the number of new highs as stocks rallied broadly. This was a marked difference from the preceding period, where few stocks participated meaningfully in the market’s upswings. By mid-2017, the surge of new highs was unmistakable, indicating broad participation and signalling to traders that this was a strong bull market. 

Another crucial aspect is the breakdown of the indicator: the number of 52-week highs versus 52-week lows. A healthy environment should have few stocks making 52-week lows - generally less than 50 stocks each day. Even if there’s a positive balance (more highs than lows), a rising number of lows can signal market deterioration. Thus, a truly healthy market shows both strong net highs and minimal new lows.

History Repeats

These dynamics of market participation and stock performance aren’t unique to the 2016-2018 bull market. Similar patterns have occurred in other strong market environments, such as the post-financial crisis bull market from 2009 to 2010, supported by broad-based stock participation. In both cases, periods of low participation and investor hesitation were followed by explosive market runs, where strong earnings, investor confidence, and increasing new highs created an environment ripe for significant stock gains

Case Studies of Individual Stocks

Let us dive more deeply into the 2016-2018 rally. As you will see, a number of stocks had staggering advances simultaneously once market conditions became healthy and supportive as indicated by continued net highs. It is not a coincidence that these stocks from different industries, geographic locations, a.nd market caps all had tremendous advances at the same time after previously being range bound. The impact of general market health, not just market trend, is vital in capturing large stock advances.

Detailed Analysis of Selected Stocks

1. Lending Tree (TREE)

• Company Overview: Lending Tree is an online loan marketplace that connects consumers with lenders. Its business model focuses on aggregating loan offers, primarily in mortgages, personal loans, and credit cards.

• Stock Performance: During the 2016-2018 bull market, Lending Tree saw its stock surge by over 270%, driven by both a strong economy and the increasing adoption of digital financial services.

• Key Breakout Points and Catalysts: The stock broke out following earnings beats in late 2016, as the company reported strong user growth and improving margins. Additionally, low interest rates fueled demand for mortgage refinancing, which was a significant driver of revenue growth during this period.

2. Baozun (BZUN)

• Company Overview: BZUN operates as an e-commerce solutions provider in China, specializing in helping brands establish and manage their online retail operations.

• Stock Performance: From July 2016 to mid-2018, Baozun’s stock skyrocketed by over 800%, reflecting the explosive growth of China’s e-commerce sector.

• Key Breakout Points and Catalysts: A major catalyst was the company’s expanding client base and partnerships with major global brands looking to enter China’s market. Breakout points were also fueled by quarterly reports showing strong revenue growth, particularly in 2017, where revenue increased 31.5% year-over-year. 

3. Green Dot Corporation (GDOT)

• Company Overview: GDOT is a provider of prepaid debit cards and related financial services, catering primarily to underbanked consumers.
• Stock Performance: Green Dot delivered a 300% gain between 2016 and 2018, as the company capitalized on the increasing use of prepaid debit cards and its push into digital banking.
• Key Breakout Points and Catalysts: Key breakout moments were linked to earnings reports that highlighted the company’s successful expansion into new banking services and its acquisition of new business partnerships, which drove consistent user growth. 

4. Nvidia (NVDA)

• Company Overview: Nvidia is a leading developer of graphics processing units (GPUs), which are used in gaming, data centers, and artificial intelligence (AI) applications.
• Stock Performance: Nvidia’s stock experienced a massive 191% return during this period, largely driven by demand for GPUs in gaming and AI, as well as cryptocurrency mining.
• Key Breakout Points and Catalysts: Nvidia’s growth was propelled by strong earnings reports, a booming gaming industry, and rising demand for AI-based technologies. Additionally, the surge in cryptocurrency mining created a spike in demand for Nvidia’s GPUs, contributing to its steep rise. 

5. Square (SQ)

• Company Overview: Square provides payment processing services for small businesses, and its Cash App allows peer-to-peer money transfers.
• Stock Performance: From 2016 to late 2018, Square’s stock soared over 700%, positioning it as one of the top-performing stocks of the period.
• Key Breakout Points and Catalysts: Square’s rapid growth was fueled by its strong revenue growth in payment processing and the growing popularity of Cash App. The stock broke out following several consecutive quarters of strong earnings, driven by increased transaction volumes and the adoption of its ecosystem by small businesses.

Lessons for Investors

The Importance of Timing and Market Environment

As these case studies demonstrate, timing is critical. Entering the market during periods of broad participation and growth significantly enhances the potential for individual stock gains. Investors should look beyond individual stock fundamentals and assess the overall health of the market to identify the best opportunities.

How to Identify Potentially Explosive Stocks in Strong Markets

Explosive stocks in strong markets typically share certain characteristics. These include strong earnings growth, participation in secular trends, and market leadership in their sectors. Investors should focus on companies that report consistent revenue and earnings beats, as well as those that are expanding their market presence or product offerings.

Risk Management in Different Market Environments

While strong markets present opportunities for significant gains, they also carry risks, especially when market conditions shift. Investors should be mindful of how quickly stocks can correct if the broader market weakens. Implementing risk management strategies, such as setting stop-loss orders or scaling into positions, can help mitigate potential losses. It is important to remember that just as a healthy market will suddenly reward healthy companies, a weakening market will swiftly punish it. No stock operates in a vacuum, and investors need to be constantly aware of changing general trends. A sudden burst of net lows would be a major cause for concern.

Conclusion

We’ve underscored the importance of going beyond market performance and  focusing on the quality of the market environment and its role in stock performance. While individual stock selection remains vital, timing your investments to coincide with favorable market conditions can significantly amplify returns. By combining both, investors can position themselves to capitalize on periods of strong growth and navigate the challenges of less favorable market conditions.