An overvalued market in itself isn’t always a concern in the near term, but a combination of low correlations and high multiples can signal a significant drop in the stock market ahead, according to James Paulsen, chief investment strategist at The Leuthold Group.

Investors have been fretting about high valuations for several years, while markets have delivered double-digit returns, on average, over the past decade. The S&P 500 SPX, -0.33% 12-month trailing price-to-earnings ratio, a common way to value a stock, is currently at 20.68 times, according to FactSet. Though the metric has come down from 23 in early January, thanks to stellar earnings. That is still near its highest level in 14 years.

Meanwhile, rolling two-year intramarket correlation of 48 industry sectors, as classified by Dartmouth College Finance Professor Kenneth French, shows that those sectors move in step with the market roughly half of the time. That rolling correlation of 0.5 represents one of the lower correlations, according to Paulsen. In fact, since 1952, rolling correlation has only been that low 3% of the time, he said.

A correlation of 1 means two assets move in lockstep, while a correlation of negative 1 implies that they move exactly in opposite direction, with a zero reflecting no relationship between the pair.

Correlations tend to rise during times of market stress because panicky investors indiscriminately sell all stocks at once.

Low correlation is typically associated with rising markets and improving investor confidence, when investors handpick their winners and losers, according to Paulsen.

Correlation can also reflect monetary policy. When the Federal Reserve is easing monetary policy, all stocks tend to benefit, regardless of which industry they are in. An accommodative central bank encourages cheaper borrowing costs to stimulate growth and that can fuel appetite for risk, pushing a swath of assets higher simultaneously.

But once the Fed is on the tightening path, correlation tends to fall as different industries and sector, (for example, banks which prosper in a higher rate environment) react differently to shifting monetary policy.

In isolation, neither P/E nor correlation have proven to be a good model for predicting when the market is about to drop significantly.

However, historically when adjusted for intramarket correlation, P/E had a much better predictive value, according to Paulsen.

Low valuation accompanied by high correlation—or when both indicators were in the best 20% bracket—produced 26.5% annualized total returns for the S&P 500.

The opposite combination, when valuation was high and correlation low resulted in the S&P 500 future average annualized return being negative 9.5%, as seen in the chart below.

“[Current elevated valuation and low correlation] represents a dangerous combination that history suggests could result in negative future stock market returns,” Paulsen said.

In a chart below, Paulsen highlights the major lows in rolling correlations over the postwar era, noting that many, though not all, negative or outright bear markets, have been preceded by such a low-correlation environment.

Paulsen concludes that while the current situation of lofty valuations and low correlation doesn’t necessarily mean the end of the nine-year old bull market, investors may have to deal with some significant downturns first.