In the Peter Schiff Show on the 5th of April, Peter talked about how low the P/E ratios of the gold mines are, compared with the interest rate. He said: "the lower the interest rates are, the higher P/E ratios will be."
This negative correlation is intuitively correct. As the interest rate is low, you won't get any return by putting your money in U.S. treasuries or in the bank. So where do you put your money, if not in cash and bonds? You will put your money in the stock market where you get a higher return. That's why stocks will have a higher valuation and consequently a higher price. A higher price will result in a higher P/E ratio. Conversely, when interest rates are high, the P/E ratio will be low.
For example: if the interest rate were 15% like in year 1981, investors will likely put their money in bonds with a 15% return per annum, rather than putting their money in risky stocks.
To show this correlation I will give historical evidence in the following charts.
On Chart 1 the P/E Ratio of the S&P 500 (NYSEARCA:SPY) is plotted against the 30-year U.S. government bond yield.
When the P/E ratio (blue line) peaks, we see that the bond yields (red line) bottom out. This is true for 1901, 1921, 1929, 1966, 1981 and 2000. Today 30-year U.S. bond yields are at 3.5%. Historically, when 30-year U.S. bond yields were at 3.5%, the P/E ratio of stocks should be around 15.
(Click charts to enlarge)
Chart 1: P/E Ratio VS. Long Term Interest Rates
This correlation might be correct for most markets, but there are exceptions to this case. For example, Japan's bond yields are at record lows (Chart 2), but its stock-market P/E ratio is still falling (Chart 3).
Chart 2: 10 Year Japanese Bond Yields
Chart 3: P/E Ratio Japanese Equities
If we look at the gold mining situation we have following Chart 4, the P/E ratio is at 15 right now (blue line). So historically, we are at fair value in the gold mining index.
But there are a few gold mines that have an even lower P/E ratio. Barrick Gold (ABX) for example has a P/E ratio of only 8.4. Newmont Mining (NEM) has a forward P/E ratio of 9.9. Kinross Gold (KGC) has a forward P/E ratio of 9.4. Goldfields (GFI) has a forward P/E ratio of 6.5. Anglogold Ashanti (AU) has a forward P/E ratio of 6.3.
These P/E ratios of the gold miners are historically low compared with the current interest rate. If the gold price correction subsides, I expect that gold miners should at least double from here to go back to their historical average P/E of 15.
Chart 4: P/E Ratio of Gold Miners (HUI Index)
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.