Fear is back, but Wall Street needs even more panic before stocks are attractively valued, according to strategist Jim Paulsen.
"If the panic progresses here (we see more evidence behaviorally of people buying assets that they typically do when they're really panicked and dumping other assets), then I think we're setting ourselves up for a really good buying opportunity," Leuthold Group's chief investment strategist told CNBC's "Trading Nation" on Wednesday.
With inflation on the rise and interest rates hovering at four-year highs, company earnings need to catch up to stock valuation before the riskier asset class can keep moving higher, says Paulsen.
These sell-offs, he explains, are not reason for concern but rather a healthy move for a market in transition.
"This is just a year where we're trying to find a new valuation level, I think, for the equity market that can withstand and sustain at a little higher inflation and a little higher yields than what we've got right now," he said.
Paulsen says 17 times trailing earnings on the S&P 500 would be a more reasonable level for the market. Analysts surveyed by FactSet anticipate combined S&P 500 earnings to rise by 19 percent to $157 a share.
"If earnings keep going up this year and we come in around $150-$160 earnings for the year, … then we're going to be pretty close, at this market level today, to 17 times earnings by the end of this year," Paulsen said.
The S&P 500's current 19.9 multiple is down from nearly 22 times earnings at the beginning of the year. The index hit a 23.5 times multiple at its 52-week peak on Jan. 26.
For earnings to catch up to valuation, Paulsen foresees one of two scenarios playing out.
"We could take care of this valuation problem with a quick swift correction which could result in even more panic than we've seen so far," he said. "Or, we could just trade up and down and go nowhere the rest of this year while earnings continue to grow and then maybe toward the end of this year we have a much more attractively priced market for 2019."
The markets are already showing signs of panic selling. Paulsen is on the lookout for typical panic plays, such as a move away from aggressive names in technology, a preference for safe-haven precious metals over industrial metals, and a pickup in defensives over cyclicals.
Paulsen expects the S&P 500 to close out the year around 2,600, its curret level. That would provide a solid setup for the rally to resume next year, he adds.
"The market will be adjusted and more prepared to sustain a rally again in 2019," Paulsen said.
A target around 2,600 represents a nearly 3 percent decline for 2018.