Commodity prices and resource stocks are likely headed lower, suggests a new BMO Nesbitt Burns Inc report.

BMO says that commodity prices are down sharply from their peaks and “will remain under serious selling pressure for much of the next year”. It notes that the global economy has cooled, led largely by the slowdown in the U.S., and demand growth in China has eased too.

“While demand growth has decelerated meaningfully, commodity supplies are rising in lagged response to the earlier record-high energy and base metals prices. Inventories are mounting, not only in natural gas, but for steel and copper as well,” it points out.

“Since earnings are very closely correlated to physical commodity prices, it is a very good bet that earnings in related companies will soon disappoint,” it adds.

BMO notes that many investors are convinced that this is just a temporary deviation from a ‘super-bull’ cycle. However, it argues that the price fall is fundamentally based. “Betting on a quick recovery in an environment of over-supply is a risky proposition for commodity-based investments,”’ it warns. “Even for goods, such as zinc and nickel, with tight supply constraints, investor interest will likely wane owing to a higher risk profile associated with such positions. Hedge funds, mutual funds, pensions and individuals, pumped tens of billions of dollars of new money into commodities and commodity stocks. As we have seen with Amaranth, the toll could be great.”

“Commodity prices typically follow a boom-bust cycle and exhibit some of the greatest mean-reverting tendencies of any market. The game is not over for this sector. Once the frothiness is out of these markets, the fundamental outpacing of demand relative to supply will re-emerge — maybe by the second half of next year,” it predicts. “In the meantime, brace yourself for further declines in most key commodity prices and their related Canadian and U.S. equities.”

This also means that the Canadian dollar has likely peaked as well, at least for the next several quarters, BMO adds.

“Remember, however, there will be winners. Energy and materials now represent over 40% of the TSX. Money shifting out of these sectors will move into other large-cap stalwarts such as financials, as we have already begun to see,” it says. “Earnings will improve for companies whose costs meaningfully decline with the fall in the price of oil and other commodities — for example the railways, airlines, and other industrials. And, defensives will also enjoy a lift in response to the slowdown in global growth.”