A Wall Street chief strategist breaks down the 4-part 'superfecta' that will keep stocks soaring

• Where some analysts fear the stock market's run-up is losing steam, Jim Paulsen, chief investment strategist at The Leuthold Group, found four reasons why stocks are set to tear higher.
• The stock market may have erased its 2020 losses, but investors remain mostly bearish and invested in safe-haven assets. This caution could give way to strong buying activity if economic sentiments improve, Paulsen said.
• The Fed's monetary policy cushion, the US economic bounce-back, and hiring activity can similarly boost stock prices in the coming months, he added.
• Here are the four reasons Paulsen sees stocks moving higher.
• Visit the Business Insider homepage for more stories.

Some analysts are growing more concerned that the stocks' valuations are overextended, but Jim Paulsen, chief investment strategist at The Leuthold Group, sees several reasons why "the horses have just begun this race."

The S&P 500's rally cooled through July after erasing year-to-date gains and entering a volatile earnings season. Several experts point to rising jobless claims and weakened consumer spending as a sign of continued virus damage and a prolonged downturn. Others fear exiting now would lead to missed profits.

The market is in the middle of a Superfecta, Paulsen said in a Thursday note, evoking the term for when a horse-race gambler correctly picks a race's first four finishers. Prices will endure a handful of pullbacks and corrections, but the collection of positive drivers should keep investors from selling off just yet, he added.

Here are the four factors Paulsen thinks can lead stocks even higher in the months ahead.

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Worried investors

The Federal Reserve's monetary easing largely relaxed investors' concerns, but market participants are still unsure how to handle their portfolios, Paulsen said. A mix of behavioral gauges suggest investors remain risk-averse. This reservedness forms a "wall of worry" to support the market from falling too sharply, the strategist said.

Investors have rotated from stocks to safe havens in recent weeks, leaving plenty of room for new stock-market inflows. Growing holdings in gold and cash assets also point to an overall bearishness, as do flows into bonds and out of stocks. Historically, such moves away from stocks eventually drive prices higher when bullishness takes hold, Paulsen said.

"Can the market 'sustain' a meaningful decline when so many investors have already sold risk assets and are waiting for a pullback to boost positions at a 'perceived' better entry point?" the strategist said.

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Race for round two

Just because the Fed's boost died down doesn't mean it's gone. The stock market has likely never rested on so strong a policy foundation, Paulsen said, and the widespread relief measures passed earlier in the year are now forming the basis for steady expansion.

The Leuthold Group's economic policy indicator — which tracks economic accommodations through fiscal and monetary aid — sits at its highest level since at least 1969. Past peaks ushered in an economic expansion lasting 5.5 years longer on average, and prompted a new bull market 85% of the time, according to the firm.

The historic stimulus and easing used to pad against the coronavirus' damage "improve the odds, dramatically, that a new economic recovery has begun," Paulsen said, adding he expects the new bull market to be in "its early innings."

Read more: 'The stock market can drop as much as 80%': A 47-year market vet explains why we're in the midst of a global bust — and makes a case for $10,000 gold

The bounce-back

The stock market retook its early 2020 highs, but economic activity remains well below pre-pandemic levels. That disparity should work in investors' favor as areas of the US reopen and spending revitalizes business activity, Paulsen said.

The strategist used an indicator comprised of weekly economic data releases — including jobless claims, consumer comfort, industrial activity, and retail sales — to gauge the US's bounce-back. Each metric is in an early stage of recovery but still has "considerable room to improve further and will likely do so as economic activities continue to restart," Paulsen said. The length and smoothness of the indicator's upswing is up for debate, but its current trend points to a recovery.

The gauge's past movements also suggest its direction is more important to the stock market than the magnitude by which it improves, Paulsen said.

"Returning to normal may not be that important. The stock market seems poised to continue rising irregularly even if the economy is still subpar, provided its 'direction' trends toward improvement," the strategist wrote.

Read more: 'The stock market can drop as much as 80%': A 47-year market vet explains why we're in the midst of a global bust — and makes a case for $10,000 gold

Filling the labor-market hole

Lastly, the damage done to the US labor market leaves plenty of room for improvement and, in turn, market gains. In a previous note, Paulsen detailed how future one-month S&P 500 returns are historically far stronger when the unemployment rate is elevated than when it sits within its middle quartiles.

The justification is relatively simple. A high unemployment rate signals strong potential for Americans to get new jobs. Hiring boosts consumer spending, and spending lifts corporate performance. With unemployment sitting at 11.1%, the market is set for stronger-than-usual returns so long as the metric trends lower, Paulsen said.

"The colossal economic divot the U.S. is now experiencing also indicates the opportunity to substantially expand economic activity during the next several years, and thereby chronically support the stock market," he added.

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