European stock retreat seen shallow, gains to come
* Europe stocks half way through expected 5 pct fall
* German stocks most vulnerable after 2012 outperformance
* Tensions in Italy, Spain trigger pullback
* Sentiment indicators, U.S. data send warning signs
* Charts show buying momentum is fading
By Francesco Canepa
LONDON, Feb 7 (Reuters) - An eight-month European stock rally that stumbled this week faces only a temporary, shallow pullback and central bank stimulus should ensure gains later in the year.
Political uncertainty in Spain and Italy led to the biggest daily index drop this year on Monday. Some national indexes have already given up all of 2013's gains.
Monday's fall of around 2 percent and caution over U.S. growth have left many betting on a further drop of 3-8 percent over the next month, with Germany's blue-chip index looking especially vulnerable.
"Tactically we just feel the market has got a little bit ahead of itself. All the sentiment indicators are now in overbought territory and the economic numbers... are just not in line with the valuations," Wouter Sturkenboom, investment strategist at Russell Investments, said.
The MSCI Europe index has pulled back in the past week, as soft corporate earnings halted a 24 percent rally since June that had been fuelled by central bank stimulus measures driving investors out of bonds and into shares.
Strukenboom said he would wait for European shares to fall 5 to 10 percent and for valuation on MSCI Europe to ease back to roughly 10.5 times its expected earnings, from a three-year high of 11.8 currently, before considering adding to his positions.
Strategists highlighted the fact that Citigroup's U.S. Economic Surprise Indicator had turned negative. This has historically heralded a pullback in the U.S. Standard & Poor's 500 index, with European stocks often following.
With Germany's Dax index heavily exposed to the U.S. economic cycle through global companies such as industrial conglomerate Siemens and car maker VW, it was seen as the most likely target of profit takers.
"The Dax has as much exposure to global growth as it does to European-centric issues," said Kokou Agbo-Bloua, European head of equity and derivative strategy at BNP Paribas.
He recommended buying options to hedge for a 5 percent fall on the Dax by March, and there were signs of investors already putting such sentiment into practice.
Investors held 57 percent more options to sell the Dax than to buy it as of Thursday, double the ratio on the euro zone blue-chip Euro STOXX 50 index, Eurex data showed.
The Dax outpaced all major European indexes in 2012 with a 29 percent rise but it has been the second-worst performer after Spain's Ibex so far this year, in a further sign investors are starting to grow more cautious on German stocks.
"We've gone from very depressed levels of sentiment last summer to quite exuberant or complacent sentiment. That's normally not a bad time to be moving to the sidelines," said Stewart Richardson, chief investment officer at RMG Wealth Management, who began taking profit on his equity holdings in mid-January.
He forecast a 5 to 7 percent fall on major stock indexes in the next five to six weeks as overly exuberant invertors came to terms with still weak economic data.
BNP Paribas's Love-Panic indicator, which aggregates other sentiment indexes to spot excessive euphoria and pessimism, showed investors were at their most positive since March 2012.
This high level of optimism, tested twice since 2011 and each time followed by a fall in equities, created the conditions for negative average returns of minus 11 percent for European shares over the next six months, the bank said.
The Love-Panic indicator has a 72 percent average correlation with equity returns, with depressed sentiment correlating with positive forward market returns and vice versa.
Technical charts on the Euro STOXX 50 and the broader Euro STOXX indexes also showed both were heading for a small pullback.
Momentum indicators such as the Relative Strength Index, which measures the strength of price changes relative to prior moves, have been falling even when the index was rising, creating what analysts call a "bearish divergence".
"We have bearish divergences in many indexes, so there are arguments to play a correction," said Ouri Mimran, technical strategist at Natixis in Paris.
He said the Euro STOXX 50 could fall up to 1.5 percent from current levels to 2,588 points, a 23.6 percent retracement of the rally started in June.
Mimran said the longer-term trend was intact, a view shared by many fund managers, who are waiting for the near-term pull back as an opportunity to re-enter the market at cheaper levels.
"Our more cautious view is for the next couple months," RMG's Richardson said. "If you were to take a longer term view, you'd be putting them into equities over the next 5 to 10 years."