Veteran Wall Street strategist reveals stocks likely to rally next

The stock market has produced big returns since April 9, when President Trump reversed course and paused many reciprocal tariffs previously announced on April 2.

The tariff time-out allowed investors to revisit forecasts for the US economy and corporate revenue and profits, which had mostly been lowered since February, when the first tariffs were enacted against Mexico and Canada.

The potential for trade negotiations to reduce the impact of tariffs on businesses, limiting the impact on inflation and earnings growth, fueled optimism that has driven the S&P 500 and Nasdaq Composite up 25% and 34%, respectively.

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The gains are impressive, but not every stock has participated equally. Many of the top-performing stocks behind the big move higher are concentrated within the information technology sector, and most boast market caps on the larger side of the spectrum.

As a result, while those stocks have arguably rallied to levels that may suggest overbought or overvalued, others could still be bargains. According to long-time Wall Street veteran strategist Jim Paulsen, if down-and-out stocks start to win over investors, it may fuel the next leg higher in the S&P 500.

Before retiring in 2022, Paulsen had been professionally involved in the stock market since 1983. His career includes being the Chief Investment Strategist at Wells Capital Management, now Allspring Global Investments, a money management firm with $465 billion in assets under management.

Do tariffs matter to stocks anymore?

A few months ago, worries were that President Trump's tariffs would either be passed on to consumers or dent corporate profit margins.

Although many tariffs were paused until August 1, President Trump's line-in-the-sand date for enforcement, 25% tariffs still apply to Canada, Mexico, and autos. There's also a 10% baseline tariff on all imports and a 30% tariff on China.

The existence of those tariffs means concerns remain, but economic data suggest that tariffs have yet to cause widespread inflation, and analyst earnings forecasts have recently improved.

The latest Consumer Price Index inflation (CPI) figures peg June inflation at 2.7%, up from 2.3% in April but down from 3% in December. Moreover, wholesale inflation, as measured by the Producer Price Index (PPI), is relatively tame, suggesting companies aren't under too much pressure to raise customer prices.

As long as inflation remains below 3%, investors may conclude that the US economy will avoid the worst-case recession scenario widely considered during the S&P 500's 19% sell-off earlier this year.

With inflation risks lessened, investor focus shifts to unemployment and what it may mean for the Federal Reserve's monetary policy. The unemployment rate is currently 4.1%, up from 3.4% in 2023.

Will the Fed cut interest rates, supporting the stock market?

The Fed's dual mandate is low unemployment and inflation, two often competing goals. Higher rates lower inflation but cause unemployment to increase, while lower rates cause the opposite outcome.

This contradictory mandate has led the Fed to leave its Fed Funds Rate unchanged in 2025 at a range of 4.25% to 4.5% while it awaits more clarity on jobs and inflation. If inflation remains controlled but job losses increase, the odds that the Fed will reduce interest rates this year will improve.

Currently, the CME's widely watched FedWatch tool puts the probability of a quarter-percentage point rate cut at the next meeting on July 30 below 3%. However, chances for a dovish interest rate cut in September are a more market-friendly 59%.

Goldman Sachs, one of the most prominent Wall Street research firms, believes the Fed will cut three times before year's end, beginning in September.

Household and business spending will likely increase if rates fall, driving corporate revenue and profitability. This will result in upward earnings estimates that support higher stock prices.

Morgan Stanley already sees this happening. According to a research note from Mike Wilson, its Chief Investment Officer, S&P 500 earnings per share revisions breadth “continues to accelerate higher (now +7%, up from -25% in April), helping to confirm our constructive view on the earnings backdrop.”

The recent passage of the One Big Beautiful Bill Act further supports the potential for corporate profits to surprise on the upside. The OBBBA contains income tax cuts for individuals and businesses that could stimulate investment and purchases.

Veteran strategist says laggards could become leaders in next stock market run

The size of the stock market's rally might have you thinking that all stocks have made major headway, but that's not the case. Many stocks haven't risen nearly as much as the broader market, which could create an opportunity for investors.

“This has been a very narrow bull market,” said Paulsen in an interview with TheStreet. “Today, we’ve got more than 76% of the sectors relative P/E (price to earnings ratio) at or below average within the S&P 500.”

Paulsen evaluated historical P/E ratios back to 1990, and he thinks that the number of sectors with below-average P/Es means those stocks could do a lot of catching up.

“You can look at the market being narrow as a sign of a weak market, as some do, or you could look at it as a sign that there's so many parts of this marketplace that have yet to be used in this bull market. And maybe they could catch fire in the latter stages here and keep this stock market alive,” said Paulsen.

Paulsen is particularly intrigued by small-cap stocks, which have been laggards.

“The Fed’s getting close to easing… I think that’s going to awaken a lot of parts of the stock market we haven’t seen yet,” said Paulsen. “And I think the biggest one of the biggest beneficiaries is going to be small-cap stocks.”

The Russell 2000 is only up 1% year to date, trailing the 7% return for the S&P 500 and the 10% return of the technology-laden Nasdaq 100 index. Historically, small caps have done best when interest rates fall, making financing expansion plans cheaper.

“I know they’ve been left for dead. And I even have trouble saying or recommending them because they’ve been dead for so long,” said Paulsen. “But I do think it’s been tied to Fed policy. And if that changes, I think that’s going to change right into the sweet spot of small-cap stocks.”

If Paulsen is correct, and rates fall, causing small caps to fall, investors may want to keep tabs on the Russell 2000 ETF (IWM) .