Stocks will roar higher if the latest 40-year high in inflation marks a peak, says a Wall Street chief strategist

• A peak in inflation is what's required for the stock market to rally, according to James Paulsen of The Leuthold Group.
• Paulsen believes the likelihood of a recession is remote.
• "If the economy is not already in a recession, history suggests the contemporary expansion may still last for several more years."

Concerns about rising inflation and the potential of an economic recession are mounting for stock market investors, but they may be overly focused on the rear-view mirror, according to The Leuthold Group's James Paulsen.

"Historically, by the time inflation topped out, the economy had already been significantly damaged, and a recession had already begun. Consequently, if a recession is in the cards today, it should be evident by now," Paulsen said in a note earlier this week.

What investors really need to see for the stock market to stop its bleeding and resume its longer-term uptrend is a peak in inflation, according to Paulsen, as historical inflationary peaks almost always led to a 12-month gain in stock prices.

"Regardless of how fast inflation moderated from its peak and whether or not a recession developed, most often, the stock market rose in the coming year! On average, among 17 inflationary episodes, the S&P 500 gained 13.2% in the 12 months following the inflation peak," Paulsen said.

Hopes that inflation hit its peak in May were dashed after Friday's CPI report, which showed prices rising at the fastest pace in 40 years. And with oil prices still surging, along with a select group of commodities, it's hard to see inflation peaking anytime soon.

But once inflation does fall, it tends to fall quickly, resembling a "V" top rather than a rounded top, according to Paulsen. That's why, based on the average decline in inflation following historical peaks, Paulsen expects US inflation could fall to the range of 4% by 2023.

If inflation cools that quickly, it would give the Federal Reserve more flexibility in its tightening cycle, and could boost consumer sentiment following months of relentless price hikes. And if that's the case, it may be that the economy is actually on better footing than some currently believe, which would help fuel buying pressure and lift stock prices, according to Paulsen.

"Considering the robust job creation, with an unemployment rate at a cycle low; S&P 500 earnings still rising; a leading economic indicator up 4.7% over the last year; and junk credit spreads still below averages since 1987 — the economy does not appear to be in a recession, nor imminently in danger of one," Paulsen said.

If Paulsen's correct, there could be big gains in store for the stock market. "If the economy is not already in a recession, history suggests the contemporary expansion may still last for several more years," Paulsen concluded.