By Toni Vorobyova and Emelia Sithole-Matarise
LONDON (Reuters) - Investors' love affair with Italy and Spain could hit a rocky patch in coming weeks, with signs that funds are turning cautious as stock and bond valuations hit multi-year highs and speculative players position themselves for a sell-off.
Confidence in the euro zone's third and fourth largest economies respectively has grown since mid-2012, when the European Central Bank pledged to stand by the euro.
But with recovery in both countries, which have been at the forefront of the euro zone debt crisis, and in their companies' earnings seen as distant, some in markets say asset prices have risen too far and too fast.
Madrid's benchmark IBEX (MCE:^IBEX) index has gained 67 percent since July 2012, pushing the premium that investors are willing to pay for Spanish stocks rather than the Euro STOXX 50 <.STOXX50E> euro zone blue-chip index to five-year highs, according to Thomson Reuters DataStream. http://link.reuters.com/xeb83v
Gains on Milan's FTSE MIB (FSI:^FTSEMIB) have been tempered by bouts of political uncertainty in Italy, but the index is still up 55 percent in the period. Italy's discount to the broad euro zone when comparing share prices to earnings expectations over the coming year (P/E) has been largely eliminated.
The premiums investors demand to hold Italian and Spanish debt rather than German bonds have more than halved from the peaks hit in mid-2012 as the ECB's pledge to buy debt of struggling countries took the heat out of the debt crisis.
"It has moved a very long way, given that there are still some risks," said Karen Olney, strategist at UBS. "It is going to be vulnerable to being disrupted with any worrying news ... we still have a bit of a crisis working through."
There are clear signs of how investors are turning more cautious. Spanish and Italian equity funds saw net outflows in August, even as pan-European funds attracted cash - the first such contrast in nearly two years, according to Morningstar.
At the same time, short sellers, who sell assets they do not own in the hope of being able to buy them back more cheaply at a later date, appear to be placing increasingly negative bets on both the Spanish and the Italian indexes.
Since the start of September, borrowing has risen 10 percent on the IBEX and 24 percent on the FTSE MIB, compared to a 16 percent fall on the German DAX (GER:^DAX), according to stock lending data from Sungard's Astec Analytics.
"Borrowing is the pre-requisite for short selling, and so we would see these numbers as suggesting there has been a build-up of short positions," said Karl Loomes, an analyst at Sungard.
The imminent company earnings season may be a reason for caution. Top analysts have cut their third quarter earnings expectations for Spain by 11.2 percent and Italy by 5.8 percent, compared with a 2.9 percent reduction for Europe as a whole, according to StarMine Smart Estimates.
In the bond market, while Italy and Spain are still finding solid demand at debt sales, allowing both almost to meet their 2013 borrowing needs, the momentum that has driven yields sharply lower may be flagging.
Italian and Spanish debt premiums over German Bunds have struggled to break below the 230 basis point mark that would take them back to early 2011 lows while 10-year yields have rebounded off 2010 lows hit in May.
"Our fair value is around here," said Harvinder Sian, a rate strategist at RBS. "To be much more constructive you'd have to see a lot more fundamental change."
"By and large we still believe in the fact that we are still in a low rates world and over time things could compress. It's feasible that with a bit more foreign demand these bonds and valuations can be pushed down to the 200 (basis point) mark (premium over Bunds)."
Technical charts also pointed to the chance of a near-term pullback in stocks, with both the IBEX and the FTSE MIB in overbought territory on the relative strength indicator.
"A pullback is likely as they are overbought but the main driver remains the long term reversal pattern (August 2011 - September 2013) that indicates a shift of opinion: the market no longer thinks that Spain and Italy are the black sheep," said 3rd Wave Consult chartist David Furcajg.
Looking further out, prospects for the European periphery start to brighten, with SmartEstimates suggesting the pace of Italian earnings growth will outpace that of the broader Europe as soon as 2014, and Spain will follow the year after.
"In terms of earnings growth it's true that these two countries will have a very big earnings recovery in 2014 and much stronger than other European countries, but it will take some time for P/Es to become normalised because it's a long way for profits to return to historical levels," said Pierre-Yves Gauthier, founding partner of equity research firm Alphavalue.
"I would think that the earnings potential is such that we could see another 20-25 percent gain in the next six months to a year on Spain, and 15-20 percent in Italy."
(Graphic by Toni Vorobyova; Editing by Nigel Stephenson and Giles Elgood)