It has been a tough road for gold stock bulls. Believe me I know. The most remarkable thing the past six weeks has been the divergence between the stocks and the metal. The action in the stocks tends to lead the action in the metal. When the gold stocks are outperforming gold, both tend to rise and when the stocks fall while the gold is going up, usually gold ends up falling too.

What has been so troubling is that the stocks have badly lagged gold since mid-March. The XAU made new lows for 2005 last week while gold rose above 435. The XAU divided by gold ratio, which rises when the stocks act stronger than the metal, has been falling since mid-March. You can see this on the chart above.

Experts have been coming up with explanations for this and rumors have abounded. One of these rumors is that a group of large hedge funds are going long the metal and shorting the stocks in some sort of arbitrage play. This could perhaps be one of the reasons for the recent action. One thing that we do know for sure however, is that the production costs for gold has risen due to high energy and commodity prices and has put the crimp on the earnings of producers. Production costs for the 6 largest gold producers was $295 an ounce in the first quarter of 2005. This is a 19% increase over 2004 costs. The result has been high profile earnings disappointments from Newmont Mining and Placer Dome, among others.

Although these production costs have certainly impacted gold stocks, I doubt that they are the sole cause of the weakness in the gold shares. Instead, I think the gold stocks are accurately forecasting a coming drop in the metal, which will result in the final bottom for gold and the stocks for 2005.

Commercial traders have greatly increased their gold short position and are now 169,289 contracts net short. They increased their short position by 18,182 contracts during the week ending May 26, 2005. Important tops in gold have been made when commercial traders have been short 150-170k contracts.

According to John Doody, who puts out the excellent Gold Stock Analyst, when you look at historical valuations of gold stocks the gold stocks are trading as if gold were at $384 an ounce. Now I don't think the price of gold is going down that far, but the fact of the matter is gold stocks are trading as if gold were much lower than it is now.

The gold stocks are factoring in a sharp drop in the price of gold.

Combine Doody's analysis with the fact that commercials are heavily short and a sharp gold correction is likely. And such a correction would be a tradeable washout bottom like we saw in May of 2004.

Wherever and however the next bottom comes, I think that the action afterwards will be similar to what we saw in 2004. Gold and the gold stocks will likely trade sideways and then both should breakout and rally by the end of the summer with the gold stocks leading the charge. We are going to see the 52-week highs broken before the year is over.

Now, what is interesting is that the correction in the gold stocks should be near an end. The downside in the gold stocks is extremely limited at this point.

Historically, once gold stocks have become as weak as they are now in relative to gold, an important bottom has been made and the ratio has begun to rally. The only exception in the past fifteen years was in 2001 when a major bear market low was made. But we aren't in a gold bear market, so such an event is extremely unlikely at this point. Gold would have to go to below 350 for that to happen and that is not going to happen. The shares of the producers are now actually cheap on a valuation basis.

The divergence between the XAU and gold has reached an extreme level only seen four times in the past five years. Each time the divergence has reached this level, the XAU has put on rallies of at least 70% started within three weeks of the time of the divergence.

Although the downside is very limited, we may not have seen THE low in the XAU yet. I still think that gold is going to fall and catch up with the gold stocks. However, at this point, the weakness in the gold stocks relative to gold should be at an end. Any further drop in gold should see gold falling at a faster rate than the gold stocks and it is that type of action that marks important bottoms in both. Yesterday the stocks rose while the metal ended down. The bottom is in sight.

To find out what gold stocks Mike Swanson holds and plans on buying subscribe to his free Weekly Gold Report at http://wallstreetwindow.com/weeklygold.htm.