* Temptation to cash in on months-long stock rally
* Near-term protection a good bet
* Longer-term investment case still solid
By Simon Jessop
LONDON, Jan 15 (Reuters) - Europe's nearly eight-month long stock rally is faltering as U.S. fiscal talks become fractious and some investors are approaching the potential turbulence without a seatbelt.
After the European Central Bank said it would defend the euro in July, they forecast sustained market gains and traded without hedging their bets.
While correctly predicting a trend that has lasted until now, analysts say it might be time for them to take precautions.
"My gut feel is there is an element of complacency creeping in," said Orrin Sharp-Pierson, global equity and derivatives strategist at BNP Paribas.
"Now would be a good time to buy some protection."
The Euro STOXX 50 has risen more than a quarter since that comforting ECB promise and those who got into the rally early may be tempted to sell up and book profits ahead of a Washington budget battle that could cause wild market swings.
And because so many are unhedged, any market fall could be amplified, which makes it a good time to buy put options as an insurance policy to lock in profits if the market falls.
"As people have progressively got longer of (bought) the equity market, they will be looking for protection, especially given the potential for shocks from the U.S.," said Nick Xanders, head of European equity strategy at brokerage BTIG.
A deal in late December only partially averted the $600 billion "fiscal cliff" of tax rises and spending cuts that had threatened to tip the U.S. economy into recession, pushing the tougher decisions back to late February.
It also means that those talks will be tied up with contentious negotiations about the limit on the amount of debt the country can issue.
President Barack Obama and Federal Reserve Chairman Ben Bernanke have both urged a deal on raising the limit, but concern over the outcome has contributed to several days of weak trade in Europe.
While Reuters most recent poll showed most in the market expect decent gains to be posted in 2013, investment banks including Credit Suisse and Goldman Sachs and brokerages such as Cheuvreux have all recently scaled back their near-term outlooks for European equities.
For those fund managers who had already chalked up a solid gain from the market rally, Cheuvreux said a degree of profit taking through February and March could prove "irresistible" and lead to a fall of up to 10 percent.
Credit Suisse, meanwhile, trimmed its "overweight" stance, as investor sentiment had become increasingly "elevated" in recent weeks, pointing to a period of consolidation. Both cited the U.S. talks as a potential catalyst.
For those who take heed of the cautious voices and look to belt up, there are good deals to be had. The Euro STOXX 50 Volatility Index, which measures expectations for swings on the cash index over the next 30 days, is at 15.70, near a 5-1/2 year low and cheap versus a five-year history.
The U.S. equivalent, the VIX, which measures volatility on the S&P 500, is even lower, at sub-14, but Xanders said both had the potential to jump quickly to the mid-20s.
"Look what happened to the VIX in December, when concerns a fiscal deal wouldn't be reached really took off. It jumped from around 16 to around 23 in several days, which is more than 40 percent."
Part of the problem for prospective buyers of protection has been that near-term expectations of market moves, or implied volatility, have still proven too pessimistic when compared with the actual market moves, or realised volatility.
While the gap has closed in recent weeks it has meant those who did opt to protect against a fall at various points since last summer have seen their options expire worthless.
"You could be forgiven for thinking the market was happier than it was, but only the really short maturities are a bit cheap, the longer maturities are about where you'd expect," said Hans Corsten, managing director of Dutch-based volatility data analysis firm Sigma28.
Using a model to see if a particular maturity is expensive, cheap or in-line with history, Corsten said a look at 30-day, 90-day, 1-, 2- and 4-year implied volatility on the Euro STOXX 50 against its five-year history showed only the 30-day volatility was slightly cheaper, with the rest in line.
That trend was also evident in the futures market.
Futures on the VSTOXX , the primary way to buy exposure to a rise or fall in the volatility index itself, show an asset manager would have to stump up rather more to protect further out, with April futures near 21 and August at 24.
"The term structure of the volatility is telling a slightly different story. Beyond the drop in the short-term volatility, the risks are being pushed back to later next year, with VSTOXX futures still trading fairly above spot prices," Vincent Cassot, derivatives strategist at Societe Generale, said.
In addition to U.S. budget talks, the politics of Europe's debt crisis and tensions in the Middle East were among other events that had the potential to trigger a spike in volatility during the year, BNP's Sharp-Pierson said.
"Which one of these is going to be fine and which one is going to suddenly spook the market? It all depends on what happens on the day."
Whatever the ultimate cost of near-term volatility, however, for BTIG's Xanders, long-term stock investors should look at it in the same way they do house insurance.
"Obviously it's wasting money every year until that one year when your house burns down... If you're long biased, it may not make you money, but it could save you a heck of a lot of money," he said.