ASX Trader: What I’m buying - the outperformer simmering beneath the surface

ASX Trader

There is a concept in investing that doesn’t get anywhere near enough attention: opportunity cost.

Most investors spend their time trying to answer one question: what should I buy?

Should I buy gold? Silver? Australian shares? Small caps? Property? Technology?

But there is another question that can be just as important.

If my investment thesis is right, what is the best way to take advantage of it?

Because identifying the right investment theme doesn’t necessarily mean you’ve identified the best investment.

We are seeing a great example of this across precious metals right now.

Gold and silver have been through substantial corrections following their extraordinary runs. More recently, both have started recovering.

But underneath those headline moves, something much more interesting has been happening.

The miners are beginning to outperform the metals.

And that relative strength could be telling us something important about where we are in the commodity cycle.

Silver is rising, but miners are rising faster.

Silver v silver miners.

Silver has rallied around 25 per cent from its recent low, yet remains more than 40 per cent below its previous high.

Now compare that with silver miners.

Silver miners have rallied close to 40 per cent from their lows and are only around 15 per cent below their previous highs.

That is a huge difference.

If an investor correctly identified the low in silver but simply bought the physical metal, they have done well.

But an investor who identified the same low and bought the stronger part of the theme has potentially done considerably better.

Both investors were right.

One simply owned the asset showing greater relative strength.

This is one of the reasons I bought SLVM, the Sprott Silver Miners & Physical Silver ETF, rather than simply increasing my exposure to physical silver.

I wasn’t only interested in whether silver was going higher.

I wanted to know what was likely to outperform if silver went higher.

Why miners can provide leverage to a commodity cycle

There is a logical reason miners can outperform the commodity they produce.

Imagine a hypothetical silver miner producing silver at an all-in cost of $40 an ounce while silver trades at $50.

Ignoring all the other complexities of running a mining company, that leaves a theoretical margin of $10.

Now imagine silver rises 20 per cent to $60 while the miner’s costs remain relatively stable.

Silver has increased by 20 per cent.

But the theoretical margin has increased from $10 to $20.

It has doubled.

That operating leverage is one reason mining companies can produce much larger moves than the underlying commodity when prices are rising.

Of course, leverage works both ways.

When commodity prices fall, margins can contract quickly. Mining companies also carry risks that physical metals don’t, including management, debt, operational problems, political risk, grades, capital expenditure and rising labour or energy costs.

That is why I don’t assume miners will always outperform.

I want the market to prove it.

And one of the simplest ways to do that is through relative-strength ratios.

Divide one asset by another

A relative-strength chart sounds complicated, but the concept is incredibly simple.

Take the price of one asset and divide it by another.

For example, divide a silver miners index by the silver price.

If the ratio is falling, silver miners are underperforming silver.

If the ratio is rising, miners are outperforming.

This removes much of the noise of simply looking at whether both assets are going up.

Imagine silver rises 10 per cent and silver miners rise 25 per cent.

Both charts look bullish individually.

But the ratio tells us something the individual charts don’t: capital is favouring the miners.

That is exactly the information I want.

And right now, the silver-miners-to-silver ratio is strengthening again off historical lows.

Where silver miners sit in on the charts.

The next step is a breakout from the larger relative-performance structure.

If that occurs, it would provide another piece of evidence that leadership within the silver theme has shifted decisively towards the miners.

Gold miners are showing the same signs

Silver isn’t alone.

Gold miners are also beginning to strengthen against gold.

One way to track this is through GDX, the VanEck Gold Miners ETF, relative to the gold price.

Gold miners have spent years trading at depressed levels compared with bullion.

That’s important because it means we aren’t looking at a sector that has already enjoyed years of relative outperformance.

We’re looking at an area that has spent a considerable period lagging the underlying commodity.

That is starting to change.

Gold miners against gold

I bought GDX last month for precisely this reason.

Gold itself can continue higher, but if the GDX-to-gold ratio breaks higher from its longer-term structure, the better opportunity may increasingly sit with the companies producing it.

And this is where the bigger commodity-cycle picture starts getting interesting.

Money moves down the risk curve

Major investment cycles rarely move every asset at the same time.

Leadership tends to broaden.

In commodities, the physical commodity can initially attract attention.

Then money moves into the larger, more established producers.

If confidence in the cycle continues growing, investors start looking further down the market.

Mid-cap miners attract capital.

Then smaller producers.

Developers.

Explorers.

Eventually, the tiny end of the market can begin participating.

It is essentially capital moving further out along the risk curve as confidence increases.

And there is an Australian chart I’m watching very closely for evidence that this process may be beginning.

Australia’s emerging companies are approaching a huge level

The S&P/ASX Emerging Companies Index, or XEC, represents the microcap end of the Australian sharemarket.

XEC compared to the XJO

What makes XEC particularly interesting in the current environment is its composition.

It is packed with small resources companies, giving investors a very different exposure from the large companies dominating the XJO.

Instead of simply looking at XEC in isolation, I compare it with the broader Australian market through the XEC-to-XJO ratio.

That ratio is now approaching a significant level around 0.40.

This is one of the most important Australian relative-performance charts I’m watching.

Why?

Because a sustained breakout above 0.40 would indicate something far more meaningful than microcaps simply going up.

It would show they are beginning to outperform the broader Australian market.

That distinction is crucial.

An index can rise 10 per cent, but if the broader market rises 20 per cent, it is actually underperforming.

Relative strength allows us to identify where capital is being rewarded most.

If XEC breaks through 0.40 against the XJO, it would represent a significant change in market structure and potentially signal the beginning of a much larger period of relative outperformance from Australia’s emerging companies.

Given the resources exposure sitting inside XEC, it would also fit neatly with what we’re already seeing across precious-metal miners.

We’ve seen this rotation before

This isn’t unique to commodities.

Markets constantly rotate between leadership groups.

Large companies outperform small companies, until they don’t.

Growth outperforms value, until the relationship changes.

One country outperforms another.

One sector becomes dominant while another spends years going nowhere.

These relationships can persist much longer than people expect.

That’s why looking only at whether an asset is rising or falling can leave investors with an incomplete picture.

The better question is often:

What is it doing relative to everything else I could own?

That is opportunity cost in its purest form.

Suppose the XJO rises 10 per cent over a period while XEC rises 30 per cent.

An investor holding the broader market still made money.

They weren’t wrong.

But they gave up 20 percentage points of potential relative performance.

Now apply the same thinking to silver.

One investor makes 25 per cent owning the metal.

Another makes 45 per cent owning the miners.

Again, both were right about the direction.

Their asset selection created the difference.

The next breakouts matter

None of this means investors should blindly buy miners or microcaps.

These assets carry considerably greater risk and volatility, particularly at the smaller end of the market.

And importantly, some of the relative breakouts I’m watching haven’t happened yet.

That matters.

A chart approaching resistance isn’t the same as a chart breaking resistance.

I want confirmation.

But the pieces are beginning to line up.

Silver miners are already substantially outperforming silver from the recent lows.

Gold miners are strengthening against gold.

And Australia’s Emerging Companies Index is approaching a major relative breakout against the XJO.

If those longer-term relative structures break higher, it would suggest something bigger is happening beneath the surface.

It could be evidence that capital is moving from the commodities themselves into the companies producing them, and eventually further down into the smaller and more speculative end of the resources market.

For investors, the lesson goes well beyond mining.

Finding the right investment theme is only half the job.

Once you’ve identified where you believe the opportunity sits, ask another question:

What is actually outperforming within that theme?

Because you can correctly identify the bottom.

You can correctly identify the next major cycle.

You can correctly identify the asset class.

And you can still leave a significant amount of money on the table by owning the wrong part of it.

Sometimes you can be completely right about where the opportunity is going, but still be wrong about what you choose to own.

Who is ASX Trader?

David Bird is known by his online persona ASX Trader. He is a Certified Financial Technician (CFTe) and former teacher who has built a cult-like following over the years thanks to his ability to use technical analysis to predict stock market movements and trends well before they unfold. Known for his sharp market insights and data-driven approach, he is co-founder of Mastering the Markets, which helps traders and investors develop the skills needed to navigate financial markets with confidence.

DISCLAIMER: Information and opinions provided in this column are general in nature and have been prepared for educational purposes only. Always seek personal financial advice tailored to your specific needs before making financial and investment decisions.