Montreal, Canada.

Two weeks ago in the Sovereign Individual (TSI) I decided to recommend our first reverse China index fund. So far, we’re up almost 13% as stocks in Shanghai have plunged over the last several days on profit-taking and fears of an imminent credit squeeze as government officials curb easy credit and manic bank lending since last November. This “bubble” is now popping.

I’m extremely bearish on the emerging markets on a short-term basis, including stocks, bonds and currencies. No other sector has been more widely embraced and legitimized by Main Street over the last few years amid a commodity bull market fuelling exports, bulging trade surpluses and high-flying currencies. This is the point of “maximum optimism.”

China is not a new trade for TSI. Back in 2005 we went long FXI or the iShares China FTSE/Xinhua 25 Index and rode a quick 65% profit before leaving Dodge as the stock market crashed thereafter in late 2007. That’s the story with China; huge gains, massive declines.

The emerging markets are now expensive and trading at a premium above major market stocks for the first time since the early 1990s. You have to go back to 1993 to see a similar price divergence that followed the “bubble” in emerging markets from 1991 to 1993. Opportunities like these don’t happen often and offer a great speculation for the aggressive investor through reverse-index funds.

Meanwhile, credit markets are also frothy.

The junk bond market remains home to the Mother of all bond “bubbles” with default rates still rising and recent data pointing to the biggest number of dollar-based defaults in history through July. Yet junk bonds are still heading to the Moon – up almost 40% this year.

TSI is also betting against junk bonds since this summer with the only reverse high-yield index fund available in the world traded in the United States.

Investment grade bonds, which continue to offer far superior values than intermediate and long-term government bonds, are also overbought. Credit spreads have crashed from a post-Lehman Brothers bankruptcy high of more than 500 basis points (5%) to just 124% basis points (1.24%) now as measured by the Dow Jones Corporate Bond Index.

I wouldn’t peg a “bubble” in corporate bonds since these companies are generally solid, large-cap companies with good balance sheets. And with government now backing the biggest bank-issued bonds there’s no fear of credit default. Still, we’ve come a long way since March and I would not buy high quality corporate debt at these levels and instead would wait for a correction before December.

The riskiest segments of the credit market are now correcting since late July. These include junk bonds and emerging market debt as spreads widen. This might be the harbinger of a greater sell-off spreading to stocks – similarly to what occurred in 2007 ahead of the subprime blow-up.

As we head into the danger-zone of stock market trading in September and October, buying more reverse-index funds or ETFs is a good idea, if history is any guide. September has been the worst month in the calendar year for stocks and credit historically. Time will tell if this is the case in 2009.