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Stocks in danger zone because 'inflation has changed its stripes,' market watcher Jim Paulsen warns

Inflation has ‘changed its stripes’ and will hurt stocks, Jim Paulsen warns

The Dow may have seen its first five-day win streak since February, but Leuthold Group's Jim Paulsen isn't running with the bulls.

The firm's chief investment strategist says he wouldn't be surprised if stocks soon retest this year's correction lows due to rising inflation.

"You're seeing more and more evidence that inflation has changed its stripes and is headed higher," Paulsen said Wednesday on CNBC's "Trading Nation." "What we're doing, as a result, is being forced to readjust interest rates and ultimately price-earnings multiples in stocks."

His thoughts came Wednesday as the 10-Year Treasury yield hit 3.014 percent — its highest level since April 26. The yield is also ticking higher, fluttering around September 2008 levels.

It's a textbook side effect of a maturing economic cycle with full employment, according to Paulsen. Stocks may have taken higher yields in stride on Wednesday, but he believes it's a temporary reaction.

"Margin erosion is starting to raise its ugly head a bit with some of the companies that have reported [earnings,]" he added. "We're going to see more of that with both labor and capital costs rising and commodity prices rising. You're going to see more companies experiencing erosion of margins, which could force Wall Street to lower estimates."

If investors aren't positioned right, Paulsen said, the damage could be downright painful. He expects the to end the year flat or slightly lower from current levels.

But he has a game plan to weather a correction-prone market.

"You can move away from the United States. I don't think overseas markets have nearly the issues that we have here," he said, adding that a commodity ETF, hedge fund exposure and capital goods sectors as places for portfolio protection.

Paulsen is also advocating cash as an option.

"The Federal Reserve is paying a little money on that now, and you might as well take advantage of it," he said. "If the market does hit another air pocket again, then you can use some of that cash and maybe the commodity ETF to go back in a bigger way towards equities."

He may have a cautious outlook, but he doesn't believe stocks have entered a bear market. Paulsen has been referring to 2018 as a "re-evaluation year."

"I am not convinced the bull [market] is over. I think this is more a pause, and maybe restart again in 2019. So, I don't want to get completely out," Paulsen said.

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