The warnings are stacking up for the US stock market, according Jim Paulsen, a Wall Street veteran and the former chief strategist at The Leuthold Group.
The longtime stock strategist has a new word of caution for stock investors, despite the market’s winning streak in the second quarter. In a recent note, he pointed to several warning signs he sees brewing, all of which point to the S&P 500 seeing a sizable correction in the coming months.
Paulsen, who has frequently flagged warning signals in the market in recent months, said he’s eyeing a stock correction of as much as 20% in the near future, though he noted the AI trade could rally much further before stocks take a dip.
“I’m getting concerned because several indicators now suggest the stock market is substantially extended and could require some period of consolidation,” Paulsen said. “My guess is any pullback may prove to be a larger 10% to 20% correction making it worthwhile to adjust portfolios a bit more conservatively for the coming months.”
Here are the warning signs Paulsen is flagging:
1. Economic policies have turned contractionary
Markets are flashing a handful of signs that economic policy is becoming more restrictive, which could hurt stocks.
Rates have headed deeper into restrictive territory amid inflationary fears from the Iran war. The 10-year US Treasury yield ticked higher to 4.49% on Monday, edging closer to the key 4.5% mark.
The government is also spending less relative to overall GDP, a sign that fiscal support is fading from the economic picture. The federal budget deficit amounted to 5.7% of GDP last year, down from a peak of 14.4% during the pandemic, according to data from the US Office of Management and Budget.
2. Oil prices have peaked
Stocks have historically struggled after oil prices hit a peak. In every instance oil has peaked over the last 50 years, the S&P 500 began to tumble shortly after crude began to fall, despite a small lag time, Paulsen said, citing his analysis of market data since 1970.
“Once oil prices finally peak, ‘pressures’ on both the economy and the stock market often are just heating up,” Paulsen said. “After obsessing about how rising oil prices would derail the bull market ever since the cannons sounded, most investors relax and become much more optimistic once oil prices peak — a telltale contrarian sign,” he added.
3. Americans are feeling worse than the market is reflecting
The S&P 500 has remained close to record-highs, but consumers are feeling worse about the economy, breaking a long-running relationship between stocks and sentiment on Main Street.
Paulsen pointed to the divergence between the benchmark index and consumer sentiment readings, with the University of Michigan’s measure dropping to an all-time low in May.
“Just another sign that perhaps the stock market’s recent run may be getting a bit extreme,” Paulsen said.
4. The stock market and the economy are diverging
The stock market looks to be running ahead of the US economy, largely due to growth in what Paulsen has dubbed “New Era” stocks, or technology and growth stocks.
Information technology stocks in the S&P 500 are up 33% this year, outstripping the 10% gain in the broader index, according to State Street Investment Management.
Real GDP growth attributable to investment spending on new-era companies has also risen to 8% year-over-year, compared to the broader 1.1% average yearly growth across the rest of the economy, Paulsen noted.
“Perhaps this massive bifurcation of success both within the economy and the stock market will continue as it has in recent quarters. However, it’s gotten so extreme in such a short time frame, I question how much longer this division can sustain before something has to change,” Paulsen said.
5. Investors are extremely bullish
Investors optimism has soared, often a contrarian indicator that hints that the next move in the market could be down.
The percentage of investors’ portfolios allocated to stocks is currently hovering around levels seen before the dot-com bubble burst, according to survey data from the American Association of Independent Investors.
“Since 1988, whenever the allocation of stocks less cash nears or exceeds 50% of the portfolio, the stock market has often struggled,” Paulsen said. “Currently this measure is at almost 55%.”
6. Liquidity is falling
Liquidity, another factor closely correlated with stock prices in recent decades, has been falling, another potential warning sign for stocks. The percentage of US corporate and household cash relative to GDP has plummeted in recent years, though the S&P 500 has continued to push higher.
“The stock market usually declined once cash stopped outpacing GDP growth,” Paulsen said, pointing to the stock declines in 2008, 2020, and 2022 as liquidity contracted. “The divergence between the stock market and liquidity levels in the economy are getting more extreme and concerning.”
