Stocks are set up to rally again as inflation drops and recession risks abate, Leuthold Group's Jim Paulsen says

• Inflation should continue to fall and that can help US stocks return to rally mode, Leuthold Group's Jim Paulsen told CNBC.
• "I think the rally will regain footing yet in the balance of this year," he said, also noting brighter prospects for corporate earnings.

US stocks have been moving lower after their surge during the summer, but the market can find fuel for a rebound from declining inflation and signs of improving conditions in the world's largest economy, Leuthold Group's chief investment strategist Jim Paulsen told CNBC.

"I think inflation is clearly headed south and it's going to continue to do that. And every time we get out a few more months, it'll be lower than it is today," he said in a broadcast interview Monday. "I think that's going to be more and more optimistic for stocks in general."

He spoke as US stocks suffered their worst session in two months, leaving the S&P 500 down 2.1%. Stocks have been softening recently after a bear-market rally began in mid-June.

But for the stock market, Paulsen said it was "very encouraging" to see the recent Citigroup Economic Surprise Index climb from a minus 80 reading at the end of last month to a minus 10. The index tracks movement in economic data relative to consensus forecasts.

"Today we're seeing some economic momentum come back, which has flattened out earnings revisions - they stopped going down on estimates this month after falling last month," and that bolsters the view that the US economy is not heading into a recession near-term, he said.

"If earnings hold together [and] inflation keeps coming down, I think the rally will regain footing yet in the balance of this year," Paulsen said.

Headline inflation in July burned at 8.5%, but that was cooler than June's 9.1% rate, a 41-year high. Falling US gas prices contributed to the decline in CPI and gas prices have continued to drop in August. The national average of $3.90 a gallon as of Monday was down by $0.51 a month ago, according to motor club AAA.

Investors were casting an eye toward the Federal Reserve's annual economic symposium in Jackson Hole, Wyoming, set to start Thursday. Chairman Jerome Powell will speak at 10 am on Friday.

Paulsen said the Jackson Hole gathering is like an extra monetary policy meeting. "At every Fed meeting, we tend to have [stock] pullbacks," he said. "Once the meeting is over, we kind of regain footing and I don't know if this is going to be a lot different."