Fear is overwhelming a market that's likely grinding higher, Wall Street bull Jim Paulsen says

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Leuthold Group’s Jim Paulsen is spotting a rarity in the record market rally: Defensive plays are driving it.

And, it’s something he can’t recall seeing in his four decades on Wall Street.

“It’s some of the most bearish or cautious attitude around that record high that I can remember,” the firm’s chief investment strategist told CNBC’s “Trading Nation ” on Wednesday.

The long-time bull points out that investors have been turning to utilities, consumer staples and REITS in droves. They have been gaining popularity as hedges against risks that include the U.S.-China trade war, Iran tensions and Treasury yield inversions.

“There’s evidence of a wall of worry, ” said Paulsen.

Yet with two trading days to go in June, it’s shaping up to be the Dow‘s best month in almost four years. The S&P 500 and the tech-heavy Nasdaq are on pace for their best months since January.

According to Paulsen, the combination of fear, room in valuations and accommodative central bank policies are setting up the market for even more upside in the year’s second half, which kicks off Monday.

“[There’s] a lot of support for this economy and this market — and a lot of fear and caution. That’s a powerful combination, I think, for higher levels here down the road,” he said.

Paulsen believes the Street isn’t bullish enough. He predicts the S&P could exceed the highest forecast on the Street, which belongs to Deutsche Bank. Its price target is 3,250, an 11.5% gain from current levels.

‘Let some of those that are fearful have them’

To profit from the next leg of the rally, Paulsen is advising investors to lighten up on what has been working.

“On strong days when the defensive stocks are running, I’d let go of some of my defensive stocks and let some of those that are fearful have them,” he said.

As sentiment turns more positive, Paulsen predicts cyclical sectors will perform the best.

“I would continue to maintain a position in the popular tech and communications area, ” Paulsen said. “You might have to hold your nose a little bit there, but I do think those sectors are going to continue to lead for as long as this bull market lasts.”