European shares rise on U.S. budget deal hopes
* FTSEurofirst 300 up 0.4 pct, Euro STOXX 50 up 0.6 pct
* VSTOXX hits 5-year low, dips below U.S. VIX
* Nokia, Alcatel surge as short sellers cover positions
* Short sellers the big losers of 2012 -EDHEC data
PARIS, Dec 18 (Reuters) - European shares rose on Tuesday, with the euro zone blue-chip index hitting a near 17-month high, as investors bet that U.S. Democrats and Republicans would reach a deal to avoid looming austerity measures.
Expectations of a deal rose in Washington, boosting U.S. stocks, after House of Representatives Speaker John Boehner emerged from a meeting with fellow Republicans pledging to press forward on talks to avert a deadlock.
The FTSEurofirst 300 index of the biggest European shares gained 0.4 percent in brisk volumes, to close at 1,137.43 points. That was just a few points shy of its 2012 high of 1,141.32 hit last week.
Cyclical shares featured among the biggest gainers, with mining giants Rio Tinto up 2.8 percent and Anglo American up 2.1 percent, while banks also rallied, with UBS rising 1.9 percent and Banco Santander gaining 2.2 percent.
"There's a lot of money being re-allocated on equities at the moment as the perceived risk is retreating," a Paris-based trader said.
"I think this rally can go on for a few more weeks, although it will seriously reduce the upside potential for indexes in the rest of 2013."
The euro zone's blue chip Euro STOXX 50 index gained 0.6 percent to close at 2,643.50 points, a level not seen since mid-2011. The blue-chip index has surged 29 percent in the past seven months, propelled in part by central banks' moves to support global growth and resolve the euro zone debt crisis.
"The rally continues, without volatility. Markets are becoming complacent and every little dip is being bought. It feels like 2007," FXCM analyst Nicolas Cheron said.
The Euro STOXX 50 Volatility Index, or VSTOXX, Europe's widely used measure of investor risk aversion, sank to a five-year low of 15.64 on Tuesday.
The VSTOXX - used to measure the cost of protecting stock holdings against potential pull-backs as it usually moves in the opposite direction to cash equities - has also slipped below Wall Street's own 'fear gauge', the VIX. That marks an unusual crossing and a further sign of investors positioning for additional gains in European equities.
"What you're seeing is a switch in investors' minds," a London-based volatility and derivatives trader said.
"People realise that the euro zone won't fall apart and they're coming back to European assets, while at the same time they are starting to worry about the U.S. budget and the risk that earnings there might have peaked already," the derivatives trader said.
A number of market players, however, warned about the risk of investor complacency about Europe, still entangled in a severe debt crisis and with much of the region either in or facing recession.
"People are lowering their guard, cutting their hedges. At the first negative news in the new year, the risk is that they will all scramble to book their profits, sparking a serious pull-back," a Paris-based equity and exchange-traded funds (ETFs) trader said.
Around Europe, UK's FTSE 100 index gained 0.4 percent, Germany's DAX index added 0.6 percent, and France's CAC 40 rose 0.3 percent.
So far this year, the FTSE is up around 7 percent, the DAX is up 30 percent and the CAC has gained 16 percent, while both the FTSEurofirst 300 and the Euro STOXX 50 are up 14 percent.
Shares in Nokia and Alcatel-Lucent jumped 7.9 percent and 8.3 percent respectively on Tuesday, extending their recent sharp rallies fuelled by improved sentiment toward the two troubled tech companies, which has prompted short sellers to cut their negative bets on the stocks.
Nokia, boosted by growing expectations of strong sales of its new Lumia smart phone models, has soared 140 percent since hitting a floor in July, while Alcatel, rising after a recent financing deal, has gained 47 percent since mid-October.
Nokia is still down 15 percent this year while Alcatel has fallen 13 percent.
The two companies have been among the most shorted stocks in Europe in the past few months.
The hedge fund strategy - which involves betting on falling stock prices by borrowing shares, selling them, then buying them back more cheaply - has been suffering this year, down 16 percent, according to EDHEC-Risk Institute data.
By contrast, the best hedge fund strategy has been to invest in so-called distressed securities - stocks and debt of troubled companies going through restructuring or facing financing issues - up 11 percent year-to-date, according to EDHEC data.