By Scott Ronalds

In Connor, Clark & Lunn’s latest outlook, they assess the recent pullback in commodity prices. After a sharp run-up that began in early 2009, many commodities have been in retreat recently. Silver has grabbed the headlines, falling over 30% since late April, but copper, gold, oil and many others have been sinking as well.

Is this dramatic reversal the end of a bull market or just a correction in an ongoing upward trend? CC&L looks at four factors in their assessment: (1) supply/demand, (2) liquidity, (3) technical conditions, and (4) the U.S. dollar.

From a supply/demand perspective, the enduring debt problems in Europe, supply chain issues in Japan, slow GDP growth in the U.S., and a deliberate slowing of economic growth by the authorities in China all point to a weakening in final demand for commodities.

As for liquidity, there is growing concern that the coming end to the recent phase of quantitative easing (‘QE2’) will take away a major source of buying (demand).

From a technical perspective, a lot of speculators may be taking some chips off the table because of the huge gains that have been realized over a short period of time. As well, sentiment may be changing as investors react to increased margin requirements. Further, CC&L notes that the recently announced Glencore IPO ($65 billion) is seen by many as a cashing-out by the largest group of commodity insiders.

Finally, the recent strengthening in the U.S. dollar (against major global currencies) is one of the key factors in the unwinding of a lot of commodity positions. Ongoing weakness in the U.S. dollar has been an important source of strength for commodities (the greenback is negatively correlated to commodity prices), but a reversal of this trend could be detrimental for prices.

CC&L feels the end result is that commodity prices will probably enter a wider trading range until the economy takes a more definitive turn (either up or down) or there is a major move in the dollar.

These factors suggest that the tailwind behind the commodity bull market could change direction in the near term. This isn’t to say that the long-term trend will be downward. A convincing case can be made that a growing world-wide middle class will be a hearty consumer of natural resources. Indeed, the China and India stories are hard to ignore. Commodities have historically been a volatile asset class, however, and there is seldom a one-way street in price movements. Moreover, history has shown that the downturns can be particularly punishing.

It is for these reasons that our funds are positioned cautiously in the sector. Our managers own very few precious metal stocks and have stayed well away from the more speculative areas of the market where valuations are hard to justify. Their focus instead is on oil & gas producers, which is a sector where they continue to see strong fundamentals and good long-term growth prospects.