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Why stocks are in store for a correction: Paulsen

Why stocks are in store for a correction: Paulsen

The stock market is stuck between a rock and a hard place, with only a narrow window open for another leg higher absent a correction, James Paulsen, chief investment strategist at Wells Capital Management, said Friday.

"We've got two conditions that make it difficult," he told CNBC's "Squawk Box." "We've got corporate profit margins which are close to post-war record highs, and we're also nearing full employment. So it's difficult to find a growth rate that is good for the stock market."

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Paulsen outlined a chain of events that could lead to a correction.

If the economy doesn't pick up because profit margins are already maximized, then corporations won't be able to juice earnings through rising margins, he said. In the event of that, earnings will be tied to sales, and if sales don't grow, then earnings will suffer, he said. That's a problem in a market that is trading at 18 to 19 times earnings.

Even if the economy picks up, markets may be unable to avoid a correction because the improvement will aggravate cost pressures because the United States is at full employment or very close, he said. That will lead to rising wage and price pressures, bigger jumps in interest rates, and concern about margin erosion and multiple contraction.

"It's very hard to find a Goldilocks growth rate right now that is good for the stock market, and I think that puts a very narrow window for a sustained advance, so maybe we're going to correct before we go higher," Paulsen said.

Read More Start of 3rd quarter: A weaker period for stocks?

One of the only ways to find growth at full employment is to resurrect productivity, he said.

"Productivity is kind of the elixir of the capitalist system," he said. "It takes a fully employed labor market and stretches that resource to allow you to grow without interest rate inflation consequence. It takes maximal profit margins and stretches the earnings cycle, and that's what we need."

The United States could see productivity rise in the next several years, Paulsen said, but he doesn't expect it to show in the next 12 months due to lack of investment.

Stocks are likely to remain range bound until the Fed commits to a date for interest rate increases, said JJ Kinahan, managing director at TD Ameritrade. He noted that the S&P 500 (INDEX: .SPX) has been stuck between 2,075 and 2,130 since early May.

For that reason, money managers are now rotating out of bonds and into high-yielding blue chip equities, he said.

"It's so funny that the safe investment of bonds has actually been the most volatile market there is right now, whereas stocks have been range bound and providing a little less strenuous, shall we say, opportunity," he told "Squawk Box."

Kinahan advised retail investors to resist an all-in or all-out mindset during this range bound session, saying there's no reason to put on huge positions at any one level.

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As for mutual fund outflows from stocks, Kinahan chalked them up to a constant stream of bad news. Greece 's debt drama and the Fed's waiting game are creating overhang in a market that is actually performing well, he said.

"We'll see what happens in July, at the end of one quarter going into the other quarter. Does a lot of the money come back in? I think that's actually what you'll see."

One sector Kinahan said he's concerned about is financials. He said investors buying into the space on the anticipation of a rate hike may be getting overexcited.

"They've done very well without the traditional banking functions, and now that they may actually get a spread, it should be exciting times for them," he said. "It may be a little bit of buy the rumor, sell the news."

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