The recent setback in the market could herald a more serious downturn.
Leuthold Group's Jim Paulsen predicts a 10% to 15% pullback will scare investors next year due to the Federal Reserve's high valuations and less accommodating policies.
"We are long overdue for a correction and we will get one," the company's chief investment strategist told CNBC's "Trading Nation" on Tuesday. "I would try to diversify away from the S&P 500, which I think could take the brunt of it."
Paulsen, a long-term bull, isn't as concerned about the economic and market impact of the Covid-Omicron variant.
"It's more likely that it's less serious than we fear right now. It's not that this is a brand new thing … we have a population that is a lot more vaccinated," he said. "The chances that it will really have a significant shutdown effect like we used to have are pretty slim."
However, given the general risk backdrop, Paulsen advises investors to reduce their exposure to large-cap S&P 500 stocks, including big tech.
“I would spend more time repositioning my portfolio – maybe I took advantage of how well technology and growth have done here over the past few months.
He believes that given the continued strong GDP and earnings growth, a severe market setback will be temporary. His S&P 500 target for the next year is 5,500, up 9.5% from Tuesday's close.
"If inflation eventually eases and we overcome Covid on a larger scale, we might see a burst of optimism in the second half of next year," he added.
Paulsen expects small and mid-cap stocks, cyclicals, and international markets to be the biggest winners.
"Look at the carnage in small caps and cyclicals," he said. "If you wanted to buy this, I would take advantage of the fear that is out there now to maybe do that."
On Tuesday the S&P 500 fell 1.9% to close at 4,567.00. It is now 4% off its all-time highs.
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