ETFs That May Be Ready to Burst

There has been no shortage of hot markets lately. Food, oil, and gold prices have been driven ever higher over the past few years. The spectacular growth of the emerging-market economies of Brazil, Russia, India, and China has received much of the credit for the increased demand for these commodities -- along with booming stock markets in those countries.

Yet the 40% decline in China's Shanghai Composite since its high point in 2007 has proven once again that good times never last forever. With a potentially slowing world economic outlook and historically high prices in many stock and commodity markets, now may be the time to consider investments that will do well if these markets reverse and head lower.

There are a couple of ways exchange-traded funds can help. Some ETFs have positioned themselves to profit when prices of the investments they track fall. Or investors can use traditional ETFs as short-sale candidates. Although short-selling isn't appropriate for many investors because of the high risks involved, those investors willing to go against the market grain and sell highfliers may eventually find handsome profits -- even if they have to experience stomach-churning losses along the way.

Developing economies and declining dollars
Since this century began, investors have heard plenty about the opportunities in investing outside the United States. Booming stock markets around the world, along with a declining dollar, have boosted returns greatly in recent years. Yet as China's example shows, those who looked for ways to lock in profits and make money from an eventual correction have already been handsomely rewarded.

One option for investors interested in shorting China's stock market is the ProShares UltraShort FTSE/Xinhua China 25 ETF (AMEX: FXP  ) . Launched in late 2007, this fund essentially does the short-selling for you, as it seeks daily investment results that correspond to double the inverse of the daily performance of the FTSE/Xinhua China 25 Index. In other words, if the index drops 1%, the fund should go up 2%.

The ever-declining dollar has been a constant for a number of years now, and everyone believes this will continue, sounding eerily like the certainty of most investors that China would experience ever-rising stock market valuations. Europe has been one of the biggest beneficiaries of the declining dollar, with the euro appreciating strongly against the greenback. Those looking for a reversal of this trend might try using the Rydex CurrencyShares Euro Trust (NYSE: FXE  ) as a short-sale play. Should the European economies start to fade and the dollar finally show some backbone, a strategy of selling the fund might pay off.

Getting buggy
Gold bugs, speculators, and investors looking for a solid source of value have latched onto hard assets like gold, pushing the yellow metal to history-making price levels. Although there are four ETFs that focus specifically on gold, the StreetTRACKS Gold Shares (NYSE: GLD  ) is the granddaddy of this elite group and has garnered the largest amount of assets. It's also fairly liquid, making trading more efficient.

The fund was launched in early 2004 and has accumulated nearly $20 billion in assets. With gold prices higher than $1,000 and demand seemingly insatiable, everyone seems to think this metal will continue to run up. That could be a sign that the gold bugs have had their day in the sun -- and betting against them might well pay off.

Commodities crunch
Oil and grains have reached record price levels as global demand has skyrocketed. An ETF designed to track oil prices, United States Oil Fund (AMEX: USO  ) , provides direct access to the performance of crude oil by investing in energy-futures contracts and similar instruments. The fund's shares rise when oil rises.

At this point, betting against energy seems like a strategy that's simply guaranteed to lose. However, with prices as high as they are, there is potential for at least some short-term fallback in prices, so shorting a fund like United States Oil could be a way to make money on dips. One example is the roughly 10% decline in oil prices and subsequent bounce back earlier this month.

Similarly, the PowerShares DB Agriculture Fund (AMEX: DBA  ) tracks an index of four widely traded agricultural commodities: corn, wheat, soybeans, and sugar. With three of these commodities linked to biofuels production, this is a fund that serves both food and fuel needs, giving it support from two hot markets. Yet if these markets finally start to cool off, using the PowerShares fund for a short-sale opportunity may prove profitable.

Portfolio fit?
In general, short sales are extremely risky. You can end up with big losses from short sales if markets continue to rise. Even if you're convinced these high-flying markets should fall back to earth, there's no guarantee that they'll do so anytime soon -- or ever.

One way to hedge that risk is to diversify short sales among a number of funds that you believe have the potential to experience declines in value. Being a contrarian can take a strong conviction and stomach, but if you're lucky, it could provide excellent returns in an otherwise dreary market.

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