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A 15 percent correction is the gut check the market needs for this bull run to continue, Jim Paulsen says

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The S&P 500 is having its worst month in nearly three years.

But the worst may be yet to come for the stock market, according to Jim Paulsen, chief investment strategist at Leuthold Group.

"My guess is that we're going to have a bigger correction than we've had yet," said Paulsen on CNBC's "Trading Nation" on Friday.

"I think a good gut check to sentiment, like a 15 percent correction, might be just the ticket to extend this bull market," he added.

The S&P 500 is currently 6 percent from its 52-week high set in late September, shy of the 10 percent pullback that represents a correction. To get into correction territory, the benchmark index would need to fall to 2,645, a level not seen since May. A 15 percent drop would take it negative for the year.

Paulsen told CNBC a correction is necessary to reflect a changing market environment where rates are on the rise, earnings are peaking, and economic growth might slow.

"What we need is a lower valuation, I think, to sustain a different environment if this recovery is going to continue," he said.

"I don't think we can handle that environment at 20-some-times trailing earnings, probably more like 15 to 16 times trailing earnings and we're a ways from that," the investor added.

The S&P 500 currently trades at 19 times trailing earnings, one of its highest multiples in the past decade. High-growth sectors including technology and consumer discretionary trade, with a multiple above 20 times trailing earnings.

"It's probably time to get more defensive and not have as much octane on from here as you have earlier in this bull market," said Paulsen, highlighting safety sectors such as utilities, staples, and real estate investment trusts (REITs) as good bets in this environment.

Defensive stocks have already taken the lead in recent months. The XLP consumer staples ETF and the XLU utilities ETF have rallied more than 3 percent over the past three months, while the XLK technology ETF and XLY consumer discretionary ETF have fallen by at least 3 percent.

Paulsen said a hard turn in the market, to favor defensive stocks over cyclicals, suggested economic trouble ahead, too.

"If defensive stocks are taking leadership, what's that say about upcoming economic growth?" he asked. "I think it suggests that economic growth is going to slow more than Wall Street really is ready for."

The U.S. economy is expected to grow by 2.9 percent in 2018, slowing to 2.5 percent in 2019, according to GDP estimates pooled by FactSet.
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