* Short selling rise; watchmakers among most targeted
* Hedge funds' long/short strategies also in vogue
* Charts bearish
* Despite 3-week plunge, valuation ratios high
By Blaise Robinson
PARIS, Oct 2 (Reuters) - European luxury stocks, once a must-have for portfolio managers seeking to avoid the European economic doldrums and get exposure to surging China sales, are falling out of favour, hit by concerns about slowing growth there.
Hedge fund bets against the sector are up and technical charts suggest further price falls after a stellar two-year run turns to profit-taking and investors turn their attention to less richly valued sectors, helped by an easing of euro zone debt crisis fears.
"Luxury stocks are losing their safe-haven status. The time when people were 'overweight' on the sector is over," said Isabelle Enos, deputy head of asset management at B*Capital.
Since a profit warning by Burberry in mid-September which spurred panic in a sector that has been used to regular profit upgrades, luxury stocks have tumbled, led by the UK fashion house itself, down 26 percent to near-two year lows.
The damage has been broad-based, with Louis Vuitton owner LVMH , Swiss watch maker Richemont and Gucci owner PPR also losing 6 to 10 percent since Burberry's warning.
SOURCE OF WORRIES
"China used to be a driver, now it's a source of worries," Diamant Bleu Gestion fund manager Christian Jimenez said.
"While portfolio managers trim their exposure to the sector and take profits, hedge funds have spotted the trend and are going 'short' on luxury, which usually amplifies the trend."
Although levels still remain relatively low, short interest in a number of luxury shares has been rising s ince Burberry's warning, with watchmakers particularly targeted by short sellers - who profit from falling stock prices by borrowing shares, selling them, then buying them back more cheaply.
According to data provider Markit, Richemont has 3.2 percent of its outstanding shares out on loan, up from 2.6 percent in late August, and Swatch Group has 7.2 percent of its shares out on loan, up from 4.8 percent in late August.
Fuelling the negative sentiment about the sector, Swatch Chief Executive Nick Hayek last Thursday said the group would have to fight to reach its sales target this year.
"The sector has been pleasing the market with strong results and resilient margins, which pushed many luxury stocks to record highs earlier this year. But the tone from executives started to change during the summer," B*Capital's Enos said.
Even reassuring comments - such as Hermes's CEO statement on Sunday that the group's targets for the year remained unchanged - are not convincing investors. Hermes stock hit a near 15-month low on Tuesday.
<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Chart on luxury goods performance and valuation: ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^> LONG/SHORT STRATEGIES IN VOGUE
If an outright short is too aggressive a trade, portfolio managers can set up a 'pairs trade', a market-neutral strategy that bets on the gap in the performances of two assets regardless of the overall market direction.
"There's just no potential catalyst for a bounce. At best, these stocks will be moving sideways for a while. For investors who are not as daring as hedge funds, the best idea is a pairs trade 'long Euro STOXX 50' and 'short luxury stocks'," a Paris-based trader said.
That trade would have added 8 percent since early September.
On the technical front, charts have signalled the end of the bullish outlook for the sector.
Virtually all the stocks suffered a break-away gap - a gap between the lowest price of one session and the highest price of the following session which indicates a brutal change in investor sentiment - on the day of Burberry's warning.
Technical analysis firm Day-By-Day has 'negative' short-term ratings on LVMH, PPR, Burberry, Richemont and Swatch, citing the recent breaks below 50-day and 200-day moving averages, seen as strong support levels.
Despite the violent pull-back in luxury stocks since Burberry's warning, shares in the sector have not dropped enough to attract bargain hunters, a number of traders warned.
Hermes still trades at 29 times expected 2013 earnings, while LVMH is at 14.7, Burberry at 13.4 and Richemont at 12.8, according to Thomson Reuters I/B/E/S data.
Overall, the sector trades at a P/E ratio of 15.3, roughly in line with its five-year average but still at a hefty premium to the market, with the STOXX 600 at 11.1.
Ratios in the sector have been buoyed by double-digit sales growth in emerging markets, but the premium is now questioned.
"These names have been the darlings of the market for a long time, but people are now realising that the luxury sector is not immune to the economic reality," Louis Capital Markets trader Jerome Troin-Lajous said.
On Monday, China's manufacturing purchasing managers' index (PMI) showed factory activity contracted for a second month in September, fuelling fears the country might be set for a 'hard landing' in which growth weakens too quickly.
"The question is: will it be a soft or a hard landing in China?," B*Capital's Enos said.
"With the sharp correction in the stocks since Burberry's warning, a mild slowdown in growth in China is now priced in, and valuation levels are back to more reasonable levels. But if it's a hard landing, then that's going to be a different story."
(Editing by Helen Massy-Beresford)
Keywords: MARKETS EUROPE STOCKS/LUXURY