[Authors note: This paper is not intended only for those who invest in the stock market or are interested in economics. It is intended for anyone who works for a paycheck, supports a family, or just cares about their future in general. If you know anyone like that please feel free to pass it on.  PDF version here.]

May 8, 2011

A few years ago I developed a weird, perverted interest in studying the nature of our Federal Reserve banking system, the history of money, and Austrian economic theory. The more I learned, the more astounded I became about how completely bizarre, unsustainable, and Machiavellian our monetary system is. And the more I studied the fundamentals of the U.S. economy, the more concerned I became that we were fast approaching and economic crisis that would dwarf the great depression.

Even after the near collapse of the entire banking system, none of the mainstream economists seemed to understand or even care about the root causes of the problem. The media was busy saying, “Crisis averted. Now back to Dancing with the Stars.” The very few who were warning about the serious flaws in our system were shouting into the wind. So, a year ago I was compelled to write a paper to warn my friends about the fundamental problems with the economy that no one seemed to be reporting. The paper was intended to be educational and was fairly matter-of-fact in tone. I was hoping to get my friends to take notice and look into ways to protect themselves from a steady dollar depreciation.

Six months later, as events continued to unfold as expected, I wrote a follow-up paper to outline some of the new developments and express more urgently how the actions our politicians and central bankers were taking were increasing the chances that the dollar would collapse. I was hoping it would spur people on to take some precautionary measures to protect themselves just in case things unfolded as I was suggesting. Those who did seem to be pleased with the 50% appreciation of their silver coins in the past six months.

Today, things are beginning to unfold fast and furious and there are some big events on the horizon that I want to warn you about just in case they don’t mention it on the evening news. The purpose of this paper is to:

1. Scare the shit out of you so you take action.
2. Entice you with the greatest financial opportunity in the history of the world so you take action.

Since I’m going for the shock and awe (no relation to Dessert Storm) I’m going to mix things up a bit and start with the conclusion. Then I’ll back track and show you how I got there.

Conclusion

As wealth cycles investor Mike Maloney likes to say, “We are in the midst of the greatest wealth transfer in history.” The question is, which side of that wealth transfer do you want to be on?

We are past the point of no return for U.S. debt. Washington has made it clear that there is no political will to do anything to solve the debt problem. Even Paul Ryan’s budget, which would throw granny out on the street and take food from the mouths of starving babies, doesn’t even begin to solve the problem. Based on the actions the Federal Reserve has already taken, very high inflation is baked in the cake and is only beginning to show up in prices at the gas pump and in the super market. Now the only question is, will it blossom into full-fledged hyperinflation or will the Fed stop the money printing and bring on a deflationary depression that would make the great depression seem like a bad night at a Warriors basketball game.

Based on the words and actions of our government and Federal Reserve officials, I believe they will try to avoid a deflationary collapse and outright default on our national debt at all costs. As a result, we will ramp up to a hyper-inflationary collapse of the U.S. dollar which will reverberate throughout the world on a scale never before seen throughout history. I believe this dollar crisis is coming certainly within the next ten years, probably within the next five and possibly as soon as the end of this year. The time to act is now!

As individuals, there isn’t much we can do to change the course of events set in motion by Washington; we can only play the hand we are dealt. I believe those who pay attention and understand what is going on can not only protect themselves, but increase their wealth dramatically in these volatile times. Sadly, the majority of Americans will be too distracted or just too busy going about their daily lives to realize that they are being bled dry at a rapidly increasing rate; until it is too late.

The good news is, anyone who is deep in debt (fixed rate debt, that is) will see their debts wiped out through inflation. The bad news is, anyone with savings in dollars, fixed income, investments in the broader stock market, or debt based investments such as bonds will be wiped out in terms of real purchasing power. The good news is that Americans have plenty of stuff- TVs, clothes, cars, and even houses to last for quite a while. The bad news is, any new goods including food and gas will become extremely expensive.

Americans will need to adjust their expectations dramatically. Most people will be forced to work well beyond today’s retirement age and many will never be able to retire in a traditional sense. The expensive toys and vacations many people enjoy today will be a thing of the past, as more of our paychecks will be devoted simply to food and energy. Unemployment will skyrocket as service sector and government jobs will need to be shed. Even people who are currently wealthy or have high paying jobs are not safe from the impending wealth destruction. Frugality will be the new fashion. Confusion, social unrest, and insecurity will be the norm.

But I’m an optimist. As Gonzalo Lira, who experienced firsthand the hyperinflation in Argentina in 1989 points out, hyperinflation eventually ends. Life goes on. The economy continues and people begin anew. America is a resilient country with a strong foundation. Hopefully, America and the world will learn the right lessons and start from scratch with a sound monetary system and sustainable economic and political policies. If that happens, America and the world can undergo a renaissance of liberty and economic prosperity like never before.

How did we get to this point?

Now that I’ve hopefully either scared you or piqued your interest enough to read more, and before you decide that I’m completely off my rocker, I’ll get in to how I arrived at these conclusions so you can judge for yourself.

If you haven’t read the original State of the Economy paper or the State of the Economy Revisited paper, I’d recommend reading them first or at least circling back after reading this. They will give you the background and context to fully appreciate the events that are unfolding now that I discuss in this paper. As you read them, ask yourself if the problems I present are being solved or are getting worse.

Then and now.

A year ago, I was concerned about the size of the national debt and deficits, the trajectory of Social Security and Medicare, and the growth in the money supply among other things. My belief was that the government would not make the tough budget cuts, including deep cuts to entitlements and defense spending, that were needed to address these issues. I also thought that they were likely to finance this spending through borrowing and money printing instead of honestly through taxation.

Since then the debt has increased by 11% from $12.8 trillion to $14.3 trillion. The 2011 budget deficit is roughly $500 billion higher than projected just six months ago. Social Security and Medicare are in worse fiscal shape. The monetary base increased by about 20% thanks to the Federal Reserve’s bond buying program, QE2.

Congress spent several months and a few continuing resolutions bickering over the size of the budget cuts that were needed for 2011 and settled on a number of $38.5 billion. That amounts to a whopping 4 days of Federal spending. And to be clear, the cuts are from the original budget request. The spending for 2011 is actually 4% higher than the 2010 budget. There was hardly a peep about entitlement spending until recently when the Republican budget plan for 2012 proposed some meaningful cuts (meaningful if you ask them; timid tinkering if you ask me). At the same time the defense budget increased and we started a new war in Libya.

How did they finance the spending? As expected, they chose the politically expedient route of borrowing and printing money. Raising taxes would have hurt the struggling economy so they continued the “Bush tax cuts” and instituted a one year 2% social security tax holiday. Unfortunately, the tax “cuts” weren’t matched with spending cuts so the Fed just cranked up the printing presses to buy up most of the new debt that was issued.

Contrary to what Ben Bernanke and Timmy Geithner would have us believe, all of this money printing has consequences. In the past year Gold is up 30%, the continuous commodity index is up 32% and silver is up 96%. This is not an accident. It is a predictable and necessary consequence of the Federal Reserve’s monetary policy. This is the “greatest wealth transfer in history” happening right before our eyes; and it is accelerating.

If things are so bad, why do most economists say the economy is improving?

The most dangerous man in the world is so cute 😉

Most policy makers and economists, including Ben Bernanke, Tim Geithner, Paul Krugman and President Obama assure us that the economy is improving, albeit not as fast as they would like. Just a little more stimulus and government “investment” should get the economy back on track. The majority of Wall Street insiders are bullish on the stock market. Why should you listen to my dire predictions when these men with far greater resumes and experience tell us things are fine and getting better?

Well, the truth is, you should seek out all points of view and decide for yourself which fits with reality. My view is basically the synthesis of the views of many outstanding economists, analysts and investors, such as Peter Schiff, Jim Rodgers, Mark Faber, Kyle Bass, John Paulson, Robert Prechter, Chris Martenson and many others, who have been proven right time and time again. The list of economists and investors warning of a major collapse in our future if things don’t change seems to be growing every day.

Contrast these men with Bernanke who has been wrong about almost everything, most notably that the subprime mortgage problem was minor and would be contained. How could so many smart people including the man who controls our entire monetary system be so off base? I believe that part of the problem is that the filters through which they view the economy are flawed.

The first flawed filter (say that five times fast) is that the numbers they are crunching to draw their conclusions are rigged. Economists use several metrics to determine the health and growth prospects of the economy including the consumer price index (CPI), gross domestic product (GDP), unemployment rate, and the national deficit and debt. In an article titled Government Numbers, I discussed how these numbers are either skewed, or don’t present the full picture. In the article I pointed out why the Core CPI understates real inflation, how our GDP growth is dependent on federal government spending financed by borrowing, why the unemployment picture is worse than commonly reported, and why the true debt picture is much worse than advertised.

The second flawed filter is what can be called the normalcy bias. The markets and the economy have worked within a certain range of parameters for a long time. Anything that deviates from that range is hard for people to imagine. People naturally expect things to continue working as they have in the past. Our system of fiat based money, running yearly deficits, Social Security, and any number of economic policies have worked in the past, so we assume that they will continue working the same way in the future. The danger is that as our economy has been seemingly chugging along for the past several decades, imbalances have been building up under the surface. Consider a thriving city built on a fault-line. Over the decades pressure builds up on the fault while life goes about normally on the surface. Periodically, the fault shifts a bit, releasing some pressure and and setting back the progress of the city a bit but then things get back to normal for a while. Things continue to work great… until they don’t. When the big one hits the results can be disastrous. As Japan recently discovered, in a complex system, events can compound to be far worse than imagined possible.

The third flawed filter is the Keynesian theory of economics they follow religiously. Past experience should have relegated Keynesianism to the dustbin of history, but the politicians and academics have perpetuated this theory because it presumes that they have the insight to manage the economy. In fairness to Keynes, even he would be appalled at the levels of spending and stimulus the government has instituted even during boom times.

But in the case of Bernanke and Geithner there may be something else going on. They are lying! Perhaps they do understand the situation, but they feel they have to lie to the public to prevent a panic. Perhaps Bernanke did realize that the subprime market was a huge problem that would spread across the full mortgage spectrum and bankrupt financial institutions, but felt that he had to lie or it would send the markets reeling. Perhaps he knows that inflation isn’t “transitory” and is much worse than the “core” CPI number indicates, but if he told the truth he would need to raise interest rates and send the economy back into recession. Perhaps Geithner knows we don’t actually have a “strong dollar policy,” but if he told the truth, foreign governments would flee from the dollar. So pick your poison; are they simply incompetent or liars? Or both?

Major Events of the Past Six Months

QE2

In September the Federal Reserve proposed Quantitative Easing 2 (QE2), a plan to buy up roughly $900 billion worth of US Treasuries from November, 2010 through June 2011, with the intention of keeping interest rates low and goosing the economy. This included $600B of new purchases and rolling over about $300B of maturing assets such as mortgage backed securities (MBSs). The program succeeded in providing a floor for the housing market and sending the stock market higher and kept interest rates low. The chart below shows direct impact of quantitative easing on the stock market. (notice the dotted line marking the end of QE2? We’ll get to that in a minute.)

Unfortunately, this creation of $600 billion dollars out of thin air sent commodity prices soaring, sending food and energy prices higher across the globe. Higher food prices were a major contributing factor to the next big event, uprisings in North Africa and the Middle East.

Unrest in North Africa and the Middle East.

It all started in Tunisia with a self-immolating fruit vendor protesting government oppression, and the protests spread like wildfire (sorry, I couldn’t resist) across North Africa and the Middle East. Well-educated youth populations struggling with high unemployment and rising food costs finally snapped and revolted against the oppressive and corrupt dictators that govern them. Some countries, such as Egypt seem to be resolving matters in a relatively peaceful manner. Others, like Libya, Syria and Yemen, are not so lucky. Our innocent sounding imposition of a no-fly zone in Libya appears to be much more involved than advertised, already costing over a billion dollars in the first few weeks. Nothing is simple in the Middle East and I wouldn’t expect these problems to go away any time soon which means prolonged upward pressure on oil beyond the damage the Fed is creating. If Saudi Arabia or Iran gets wrapped up in this, $4 gas will look dirt cheap.

Japan Tsunami and Nuclear Fallout

The tsunami in Japan killed over twenty thousand people, destroyed countless buildings  and caused a nuclear catastrophe that was eventually classified at a category 7 accident, the most severe level. The US stock market reacted by taking a deep breath, and then continuing on its QE induced binge. Apparently, the world’s third largest economy suffering its worst disaster since WWII just isn’t that big of a deal, or at least, not that big of a deal for the US.

In fact, it’s a huge deal and the fallout is only just beginning to emerge. The cost of reconstruction is estimated by the Japanese government to be over $300 billion. This doesn’t include the loss in productivity due to rolling blackouts in Tokyo and other cities or the impacts of nuclear radiation which are still not fully known. This affects world economy in two major ways.

First, many products, even if not assembled in Japan, contain components made in Japan. Not all of these components are easily interchangeable. The supply chain disruptions will affect many companies worldwide, especially in the automotive and electronics sectors. This may have had a minimal affect on Q1 earnings for some companies but the real affects will show up in the July earnings season, just a few weeks after QE2 is set to expire. The timing could be disastrous for the stock market.

The second major impact is the disruption to global capital markets, especially Japan’s US Treasury holdings. Japan’s knee-jerk reaction to the crisis was to print more money, which was about the worst thing they could have done. As a country with few natural resources, Japan will need to buy steel, copper, oil, and other resources from other countries and a weak Yen will make everything they buy more expensive. They will need a boatload of cash to buy the materials they need to rebuild their country. Luckily, they have nearly $900 billion in US treasuries that they can sell to finance the reconstruction. At the very least, it’s likely that they won’t be buying any more US treasuries, and as their own borrowing costs increase, they may be sellers of US debt.

European debt problems continue.

The debt crisis in the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) that sprung up in late 2009 was temporarily swept under the rug through a series of austerity measures and bailouts by the European Union. The story dropped from the front page headlines as the unrest in Africa and the tsunami in Japan grabbed our attention. Now the problems in the PIIGS are back in the forefront, as apparently they didn’t kick the can very far down the road. Portugal was forced to ask for a bailout, the Irish people are balking at the bailout deal their government negotiated to pay back the bankers, and Greece is seeing its interest rates soar above 15% on the ten year bond. Greece will likely need to restructure (i.e. default) it’s debt. The high interest rates, austerity and social unrest in the PIIGS is a warning of what’s to come to many state governments in the US and eventually the federal government.

Housing market update.

The housing market remains fragile at best. New home construction in February dropped to its lowest level.  February home prices fell 3.3% from the year earlier despite artificially low interest rates. As this 60 Minutes report discusses, the robo-signing mess is still going on. If anyone can watch that video and explain to me how no one is in jail for this fraud, I would appreciate it.

Upcoming Events – A Summer Meltdown?

Debt Ceiling Vote (the little event)

Sometime in the next few months, depending on how long Geithner can fudge the numbers, the U.S. will reach its legal borrowing limit, and Congress will need to vote on whether to raise the debt ceiling. This is nothing new. Since 1962 the debt ceiling was reached 74 times and every time Congress voted to raise the limit. The main difference this time around, aside from the sheer magnitude of the debt, is that the rest of the world is finally making noise about the US simply printing more money to pay its bills while everyone else suffers through austerity and rising inflation.

If the debt ceiling is not raised, the government would need to immediately raise tax revenue and cut spending by a combined $700 billion just to fund the government through September. Barring that we would default on our debt, which would devastate the U.S. and world economy. The good news is that there is almost zero chance that congress won’t raise the debt ceiling. The bad news is, the alternative may be much worse in the long run.

The Republicans are talking tough about using the threat of not raising the debt ceiling to extract “sweeping” budget cuts from the Democrats along the lines of Paul Ryan’s proposed 2012 budget. Some Tea Party types are calling for a balanced budget amendment. The world will be keeping a close eye on how austere these cuts actually are and how much is actual cuts vs. promises to cut in the future. Using Paul Ryan’s budget as a baseline, it looks like the best we can hope for is a mild slowing in the rate of increase of the national debt. In the eyes of the world, the vote to increase the debt ceiling will cement in stone the fact that the U.S. won’t make substantial cuts until we have no other option.

The End of QE2 (the BIG event)

The Federal Reserve just released the conclusions of its April meeting on monetary policy, and Ben Bernanke held a historic, first-of-its-kind press conference to soothe the wary public. Amazingly, the conference went off with nary a lip-quiver from Ben as he summed up the Fed’s findings and fielded softball questions from the media. The report was in line with what most Fed followers had expected. The Fed funds rate remained unchanged at 0%-.25% and would likely stay that way for a sustained period. The $600 billion in bond purchases from QE2 would end as scheduled at the end of June. The Fed would maintain the size of its balance sheet going forward as the market dictated.

It’s this third provision that requires careful scrutiny. By the end of QE2, the Fed’s balance sheet will have ballooned to about $3 trillion, about half U.S. Treasuries and half MBS’s and other debt instruments. As these assets mature, the Fed will continue to reinvest the proceeds into U.S. Treasuries. The implication is that if the Fed deems that the economy is growing fast enough or inflation gets too high, the Fed can tighten monetary policy by not reinvesting the proceeds or selling assets to reduce its balance sheet. However, this carefully worded statement also leave open the possibility of increasing the balance sheet, i.e. QE3 if the economy crashes.

The trillion dollar question is: When QE2 ends at the end of June, who will buy U.S. Treasuries? The charts below from PIMCO ask that very question.

The chart on the left shows that historically, Treasuries were mostly purchased by foreign governments and American investors with only 10% soaked up by the Fed.

The middle chart shows that since QE2, the Fed has been buying up 70% of the Treasuries to keep rates artificially low. Foreign governments bit the bullet and bought the other 30% of Treasuries, mostly to keep their own currencies from rising against the dollar.

The chart on the right asks who will buy the bonds once QE2 ends? The April 27th Fed statement answers part of that. The Fed will continue to roll over its maturing debt which will account for roughly 30% of new bond issuance. But who will buy the rest? Foreign governments currently buy 30% but will they keep it up?

The biggest foreign buyer of bonds has been China, who owns roughly $1.3 trillion worth of our debt. Several key economic policy makers in China recently stated that China’s $3 trillion in foreign currency reserves is excessive and should be reduced by roughly two-thirds. Instead, they should use their savings ”to acquire resources and technology needed for the real economy.” They have already begun this process, but if it starts in earnest, the Chinese will not be rolling over much of their expiring U.S. debt and may be sellers.

Japan is the second largest buyer of Treasuries and as discussed above, the cleanup costs from the tsunami will likely mean that they will stop buying new debt and may be net sellers.

Bill Gross, head of PIMCO, America’s largest bond fund, has stated that they will no longer be buying U.S. Treasuries and recently began actively shorting Treasuries. Interest rates would have to rise substantially to get him back in the game.

So basically, the Treasury has a lot of bonds to sell and not a lot of buyers. That means starting in July (if not before), the interest rates will need to rise to attract new buyers. Rising interest rates have several implications, all of which are bad news for an economy addicted to cheap credit.

1. The price of Treasuries and other debt instruments such as mortgage backed securities will fall. This will destroy the value of bank balance sheets, pensions, retirement plans with “safe” U.S. bonds, and the balance sheet of the Fed itself.
2. Mortgage rates will rise which will hurt an already double dipping housing market. Adjustable rate mortgage payments will shoot up as home values drop causing a whole new wave of foreclosures and bank bankruptcies.
3. The government will need to pay higher interest rates to borrow which means the interest payments to service that debt will take up a much larger portion of the budget moving forward.
4. The rising interest rates will slowly draw capital from stocks into bonds. This, along with tight credit, failing banks, shrinking profit margins, loss of consumer purchasing power and supply chain disruptions from the tsunami will put downward pressure on the stock market.

I believe that the four outcomes listed above are almost certain to play out; it’s just the matter of degree that is unclear. Perhaps the Fed can provide some hidden backdoor stimulus to soften the blow (In addition to 0% interest rates and continuously rolling over its maturing debt). Perhaps the world will view the “end” of QE2 as a message that the Fed is beginning to tighten and they can pour back into treasuries. On the other hand, perhaps there really are no buyers and interest rates will rise to the level they are seeing in Portugal or even Greece.

The biggest uncertainty for me is where will investors and governments around the world turn to find a safe haven. After the bursting of the housing bubble and ensuing financial crisis, people around the world flocked to the U.S. dollar and government bonds as the safe haven from a crashing economy. Will it play out the same way this time around? Or will they go to Euros, Swiss Francs, Aussie Dollars and Norwegian Kroners? Or will they flock to gold and silver?

If they rush back to the dollar, commodities and precious metals will likely drop with everything else as they did after the financial crisis. In fact, since Bernanke confirmed the end of QE2 on April 27th, the Continuous Commodity Index is down 7% and the dollar is up slightly. If the dollar strengthens, credit will tighten, net exports will drop, and we will resume the downward trajectory we were on after the financial collapse. How long do we expect Helicopter Ben to sit idly by as the stock market tanks, his friends in the banking sector are eviscerated, and the interest on our national debt skyrockets?

The answer is, not long. And what comes next? QE3! Although maybe by a different name in a slightly different form. But make no mistake, the Fed will crank the printing presses on full blast. And when they do, the dollar is toast, inflation will kick into high gear, and commodity prices will continue their march higher.

But the strengthening of the dollar we saw after the financial collapse might not even happen this time around. Instead of flocking to the dollar, people and governments might just skip the head fake in the dollar and go straight to commodities and more sound currencies. Central bankers from China to South America have been bemoaning the depreciating dollar. The BRIC countries (Brazil, Russia, India and China) recently made a deal to denominate debt purchases between the countries in their own currencies. China and Russia recently agreed to use yuan and rubles for trade between the two countries. Several OPEC nations have discussed using a basket of currencies in oil transactions. Even the IMF has hinted that the dollar may be approaching its final days as the reserve currency. The Fed has declared 0% interest rates for the foreseeable future while other central banks are tightening. If this continues, the dollar has nowhere to go but down and QE3 will need to be even bigger.

What does it all mean?

The world is going through some major changes. For forty years the world’s reserve currency has been backed by nothing but the full faith and credit of the U.S. Government. Unfortunately, our government has abused that faith. Since then, the world has seen an incredible expansion of credit and debt like never before. Productivity and real wealth has grown considerably, but that wealth creation has been eclipsed by the mountain of debt and derivatives and paper assets that have been leveraged on top of that wealth.

As this occurred, the production center of real wealth shifted to emerging markets and especially China while the appearance of wealth grew in developed economies and especially America as we printed and borrowed and leveraged our way to prosperity. As credit expanded it formed a series of bubbles, each one bigger than the next. Each time, the politicians and central bankers refused to let the bubble fully correct. Now we have reached the final bubble. The Fed is running out of magic tricks it can pull out of its hat. Each new stimulus is bigger and less effective than the last and people around the world are realizing the party’s over. Call it a credit bubble, or a derivative bubble or a confidence in paper money bubble, but it will soon pop, and no government is big enough to bail it out.

The result will be a collapse in paper assets while real things and real production will become relatively much more valuable. Just as the owners of dot com stocks saw their paper wealth vanish seemingly into thin air, those holding paper assets including the dollar will find that the wealth they thought they had was only an illusion.

Time to take action 

What do I mean by “take action?” The most important thing you can do is take an active role in your financial well-being and learn as much as you can about economic history and current events. It’s up to you to determine what actions are right for your situation. Don’t assume that your stock broker knows what he’s doing. His job is to sell you stocks. Don’t assume that your 401k is a safe retirement plan. Their job is to invest in a diverse portfolio while taking generous fees in the process. Don’t assume the you are diversified if your salary, savings, and investments are all denominated in dollars and reliant on the strength of the U.S. economy.

And don’t just blindly follow my advice either. I’m not trying to tell you what to do, I’m just trying to alert you to what I believe are the major transformations happening in our economy. The previous state of the economy papers had some specific suggestions of actions you can take if you agree with my view of the economy. I won’t repeat them here to avoid being redundant. The Liberty Insight blog has a variety of articles and external resources you can read to learn more about this perspective. One new resource that I want to mention is Peter Schiff”s radio show. You can download it commercial free at schiffradio.com. If you listen to his show for a month you will know more about how the economy really works than Nobel prize winning economist Paul Krugman.

Also, keep in mind that the political and economic landscape is changing dramatically every month. It’s important to keep up with what the government is doing and adjust your strategy accordingly.

A quick note about gold and silver.

As I’ve mentioned before, the easiest way to have access to commodities is to own gold and silver. If the dollar is devalued, the dollar price of all commodities including gold and silver will continue to rise. However, gold and especially silver can be very volatile so it is important to gain a true understanding of the gold and silver story so you will have the conviction to ride out any volatility in the market. When I began writing this report, silver had just gone though a parabolic rise in price gaining nearly 70% in three months. I was a little apprehensive about advising people to jump into silver after such a large gain. Well, we’ve been given a gift from the heavens as silver has dropped nearly 30% in one week. This is great news for people looking to buy silver because you can buy that much more silver for the same amount of dollars. Fundamentally, nothing has changed if you believe the dollar will be devalued thus silver will rise story.

So what caused such a huge drop in one week? The biggest factor was the huge run-up in the previous months. It was way too far too fast and was in need of a correction. The likely trigger for that correction was the CME raising margin requirements five times in eight days a cumulative 85%. This shakes out week, leveraged speculators who are forced to sell. It also coincided with George Soros selling silver and Eric Sprott diversifying out of his PSLV ETF (although into other silver assets).

Whatever the reasons, silver is at a much more stable buying level. The premium on PSLV has dropped from a very high 22% to a reasonable 12% which is slightly below the mean. Will silver continue to drop in the next few weeks? Maybe. Will it shoot back up now that the weak hands have been shaken out? Possibly. My personal feeling is that it will zigzag sideways in the $30-$40 range until the announcement of QE3 sometime in the fall, at which point it will resume its rapid ascent. The point is, it’s very difficult to time the market so the best approach is to dollar cost average in by buying a chunk at a time until you reach your desired allocation. Just be ready and if the Fed announces QE3 then it’s time to buy with both hands.