During the stock market turmoil, the buy-and-hold crowd is keeping the faith. That is not a good thing, as I explain later in this column.

One of the biggest risks with this stock market is the rise of passive investing. Please see “Would you be prepared if the Dow Jones Industrial Average were to fall 5,700 points?” Let us explore with the help of a chart.

Please click here for an annotated chart of S&P 500 ETF SPY, +1.61% . Similar conclusions can be drawn from a chart of the Dow Jones Industrial Average DJIA, +1.33% ; charts of the Nasdaq 100 ETF QQQ, +2.32% and small-cap ETF IWM, +1.62% show more selling. Please note the following:

• The chart shows RSI (relative strength index) divergence. In plain English, this mean that as stock prices have gone down, RSI has risen. This is positive and indicates a rebound.

• The chart shows Arora’s first target, given in advance, was reached. We shared with our subscribers in advance: “If traditional technical analysis holds, there should be a retest of the 2,710 level in the S&P 500. If a retest takes place, hunt-and-destroy algorithms may try to take out stops that naïve investors have placed under 2,710 and then under 2,700. These algorithms may drive the S&P 500 to 2,690. On the positive side, the stock market is oversold. Oversold markets tend to have strong rallies. For this reason, those who are thinking of short-selling here need to be extra cautious (slightly edited for readability).”

• The chart shows that our call was spot on. S&P 500 futures dipped to 2,692.25 and then proceeded to stage a strong rally. Our call was for a dip to 2,690. In this business, it does not get any better than that.

• The Arora Report called the rebound shown on the chart suspect due to many characteristics. First, weak hands were not taken out. When weak hands are taken out, the rebound becomes more sustainable. Second, volume was lackluster, indicating the lack of conviction in the rally.

• As shown on the chart, volume was relatively low during the decline and the rebound, and also during the subsequent drop. This is a negative beyond the very short-term bounce.

• The chart shows the support zone.

• As expected, high-beta stocks were hit disproportionately hard. High-beta stocks are those that move more than the market. Notable among FAANG stocks for their high beta are Amazon AMZN, +2.49% and Netflix NFLX, +2.07% , though Apple AAPL, +3.75% , Google GOOG, +1.16% GOOGL, +1.13% and Facebook FB, +2.12% were not spared. Those are the stocks that also rebound the most. Among popular semiconductor stocks, AMD AMD, +2.94% , STMicroelectronics STM, -2.34% , Nvidia NVDA, +4.25% and Micron Technology MU, -0.66% have been hit. Tesla TSLA, +5.04% has rocketed up on good earnings and a short-squeeze, showing that individual stories matter even when the market is falling.

Texas Instrument’s TXN, +1.19% earnings are especially noteworthy because they indicate weakness is coming in several important sectors of the economy. AMD stock was pummeled hard after earnings because the momo (momentum) crowd had artificially run it up and the stock had become very expensive. Microsoft’s MSFT, +2.27% gross margins fell for the first time in eight quarters, but the bulls are ignoring it — a sign of complacency.

Popular marijuana stocks such as Canopy Growth CGC, -0.70% , Aurora Cannabis ACB, -2.88% , Tilray TLRY, +0.84% and Cronos CRON, -0.97% have suffered after a big run going into Canada legalization.

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Buy and hold

The volume from the chart, intraday money flows and anecdotal evidence shows that the buy-and-hold crowd has kept the faith. They did not sell. The buy-and-hold crowd operates on the assumption that the next 50 years will be similar to the past 50 years in terms of the long-term uptrend in the stock market. Do you really know if this will be the case?

No cathartic flush

I would have liked to see a cathartic flush for two reasons.

• It would have taken out weak hands.

• It would have shaken the prevailing complacency among the buy-and-hold crowd.

If those two things do not happen, it is good in the very short term, especially since positive seasonals are coming. However, it is not a good thing for the long term.

What to do now

Investors may consider holding good positions but also taking some defensive measures. The most important defensive measure is to follow a proven model that has worked well in both bull and bear markets. The model should be comprehensive and encompass macro, fundamental, technical and quantitative factors. (An example of such a model is the ZYX Asset Allocation Model with 10 inputs. Please click here to see the 10 inputs.)

Markets are dynamic. Nothing is cast in stone. Cash levels and hedges need to be frequently adjusted to provide the highest risk-adjusted returns, i.e., returns higher than those commensurate with the risk taken.

Please see: How one investor sidestepped this week’s stock-market decline.

Disclosure: Subscribers to The Arora Report may have positions in the securities mentioned in this article or may take positions at any time. Nigam Arora is an investor, engineer and nuclear physicist by background who has founded two Inc. 500 fastest-growing companies. He is the founder of The Arora Report, which publishes four newsletters. Nigam can be reached at Nigam@TheAroraReport.com.