The latest market setback may be a foreshock to a more serious downturn.
The Leuthold Group's Jim Paulsen predicts a 10% to 15% pullback will rattle investors next year due to high valuations and less accommodative Federal Reserve policies.
"We are way overdue for a correction, and we're going to get one," the firm's chief investment strategist told CNBC's "Trading Nation" on Tuesday. "I would be trying to diversify away from the S&P 500, which I think might take the brunt of it."
Paulsen, a long-term bull, isn't as concerned about the economic and market impact of the Covid omicron variant.
"It's more likely to prove to be less serious than we fear at the moment. It's not like this is a brand new thing... We have a population that's far more vaccinated," he said. "The odds of it really having a significant shutdown effect like we had earlier are pretty low."
But due to the overall risk backdrop, Paulsen is advising investors to start reducing exposure to large cap S&P 500 stocks, including Big Tech.
"I would spend more time on repositioning my portfolio — maybe taking advantage of how well tech and growth has done here in the last few months. Moving a little out of that," said Paulsen.
He expects a major market setback to be temporary due to continued strong GDP and earnings growth. His S&P 500 target for next year is 5,000, which implies a 9.5% gain from Tuesday's close.
"If inflation does moderate eventually and we do get beyond Covid in a bigger way, then we could really see some optimism breakout maybe in the latter part of next year," he added.
Paulsen expects small and mid-cap stocks, cyclicals and international markets to emerge as the biggest winners.
"Look at the carnage in small caps and cyclicals," he said. "If you've been looking to buy that, I'd take advantage of the fear that's out there now to maybe do that."
On Tuesday, the S&P 500 fell 1.9% to close at 4,567.00. It's now 4% away from its record highs.
Correction: A previous version incorrectly stated Jim Paulsen had an S&P 500 price target of 5,500 for 2022.