Jim Paulsen sees a warning sign that should have investors shifting their game plan

  • While the four variables that are traditionally recession indicators aren’t lining up right now, Jim Paulsen sees another element in play that is predictive of future market returns.
  • He would stay in the market but would diversify much more broadly and aggressively.

Noted strategist Jim Paulsen has his eye on a metric he believes may be a warning sign for the market.

While the four variables that are traditionally recession indicators aren’t lining up right now, he sees another element in play — the real earnings yield. That is the most recent 12-month period of earnings per share divided by the current market price per share.

“The real earnings yield has had a pretty good track history over the post-war period ... of kind of giving an idea of future return potential,” Paulsen, chief investment strategist at The Leuthold Group, told CNBC on Tuesday.

“Real yield sits right on the cusp of the lower quartile and half of the bull markets in post-war history — more than half actually — have ended when the real yield fell to the lowest quartile,” he said on “Power Lunch.”

That doesn’t mean he’s predicting a recession at the moment. Right now, Paulsen believes the market is highly valued and there are limits to how much higher the bull market can go.

“The real risk is if the cycle ends. That’s where the negative return potential comes in,” he said. “If the cycle continues, I think values will allow it to continue to rise.”

However, investors should be prepared.

“I’d stay in the market but would diversify much more broadly and aggressively then we have up till now,” he said.

How to play it

For one, international markets should be “maximally overweighted” relative to U.S. stocks, Paulsen said.

“Most of issues are more pronounced here than they are abroad. Overseas markets are under-owned, undervalued, they have more accommodative policy officials, a number of good attributes,” he noted.

Paulsen would also raise a little cash, which would come in handy to scoop up opportunities during the next sell-off.

“If we do hit another air pocket and go below February lows, there’s going to be a lot of panic and you’ll have some dry powder available as people give away good assets.”

He would add a little gold for the same reason, since panic from a sell-off would send the precious metal higher.

A commodity exchange-traded fund would also be a good idea because full employment and a high gross domestic product number, perhaps at 5 percent, would be beneficial for commodities, he said.

Second-quarter economic growth numbers are due out Friday. Economists expect an expansion of 3.8 percent, while CNBC’s Rapid Update tracker projects GDP to rise 4.2 percent in the quarter.

When it comes to U.S. stocks, Paulsen would diversify his sector exposure and buy inflationary beneficiaries like industrials, energy and materials.

'The trade for the year'

For Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management, the focus should be off of momentum players.

“The trade for the year is don’t chase too much momentum. If things have worked too strongly, back off. And then look at areas that have not done as well,” he told "Power Lunch."

Right now, the market is doing great because of corporate earnings, Slimmon said. But it will be a tougher time come August, when earnings are over and the market is only facing geopolitical headwinds, he added.

Slimmon specifically likes financials, which have lagged but he thinks can do better.

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