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INVESTMENT FOCUS-Big merger flops may stall Europe's stock market rally

* High-profile bid attempts in Europe hit hurdles

* Weir dropped bid for Metso this week

* Omnicom and Publicis cancelled merger plan

* Bid for Alstom businesses faces political hurdles

LONDON, May 30 (Reuters) - Investors looking for big merger-driven gains on Europe's stock markets this year are having to temper their expectations after a number of multi-billion euro deals have fizzled out.

Traders and investors remain optimistic that overall merger activity will increase, spurred by Europe's gradual economic recovery. European merger volume has already nearly doubled over the last year, according to Thomson Reuters data.

But a string of botched takeovers in the past few weeks has made traders and investors more sceptical of the potential for M&A-fuelled share-price rewards - especially for big deals that carry increased political and execution risk.

"The mega-deals are proving ever more difficult, as the politicians get involved," Rupert Baker, an equity sales executive at Mirabaud Securities, said.

"I don't think we'll see any big deals for the next few months, and you could be in for a lull on the market."

There is a close correlation between markets and mergers.

The pan-European STOXX 600 index is up by 5 percent since the start of 2014, helped by the resurgence of dealmaking, which typically pushes up the shares of takeover targets.

Historically, the STOXX 600 has peaked alongside deal volumes. It hit a high of around 400 points in mid-2007 just as European M&A monthly volumes hit their highest since November 1999, before markets slumped as the 2008 financial crisis hit.

This year's deal revival that has helped to drive stock markets higher has started to hit some big hurdles.

Earlier this week, shares in drugmaker AstraZeneca dropped after U.S. rival Pfizer walked away from making a formal bid for AstraZeneca potentially worth about $118 billion.

The two companies had been locked in a month-long public fight over the proposed deal that sparked political concerns on both sides of the Atlantic over jobs and tax manoeuvres.

Just days later, engineering group Weir dropped a bid for Metso after the Finnish company rejected a second, sweetened takeover offer. Shares in both companies fell.

Advertising groups Omnicom and Publicis also ditched a merger at the start of May, while attempts by GE and Siemens to bid for parts of France's Alstom have been complicated by political meddling.

Even though dealmaking has picked up over the last year, M&A activity globally dropped 41 percent in May from levels reached in April, according to Thomson Reuters data.

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Graphic showing STOXX 600 vs M&A volumes correlation

http://link.reuters.com/muh55t

POLITICAL HURDLES

Fund managers said that a lot of the big-name failures were due to political and regulatory risk, rather than simply price.

"I don't think valuations are a problem, it's more the political hurdles," Terry Torrison, managing director at Monaco-based McLaren Securities, said.

Valuations are attractive overall, with the average enterprise value to core earnings (EBITDA) ratio - used by bankers to evaluate the price of a takeover - having fallen to 6.7 from 7.3 over the last year, according to Thomson Reuters StarMine.

Most investors are still betting on more long-term gains over the course of 2014 for European stock markets. A Reuters poll in March of fund managers and strategists showed that, on average, they expected the STOXX 600 to end 2014 at a six-year high of 353 points - up from current levels of around 344 points.

And there is a steady flow of smaller deals, such as French software company Atos's plan this week to buy rival Bull in a 620 million euro transaction.

But the collapse of mega-deals such as Pfizer/AstraZeneca has led to doubts that the long-awaited revival of European M&A will be as smooth a ride for investors as expected.

"We are at the start of a new M&A cycle ... The problem today is that I would say deals are taking much longer than before to be finalised," Lionel Melka, a partner at Paris-based fund Bernheim Dreyfus, which bets on merger activity, said.

Melka cited the growing influence of governments. He pointed to China's Ministry of Commerce, which is increasingly using antitrust rules to impose conditions on global deals such as the $35 billion Glencore Xstrata merger, which took more than a year to complete.

One M&A banker said that while smaller, "bolt-on" deals were proving relatively easy to execute, the bigger ones were harder.

"Transformational deals are just that little bit more difficult," the banker, who declined to be named, said.

Shares in UK medical devices company Smith & Nephew initially spiked up 17.5 percent on Wednesday this week on speculation of a potential multi-billion dollar bid from U.S. rival Stryker. But Stryker then denied it was planning to make an offer.

The market for initial public offerings (IPO) has also had some setbacks, with clothing chain Fat Face cancelling a market listing earlier this month, while British holiday-to-insurance company Saga had to price its market listing at the bottom of a pre-set range.

Michel Juvet, chief investment officer at Swiss bank Bordier, said that signs of failed bid attempts could stall the European stock market rally in the short-term.

"If you see less investors trying to buy the next target, and less investors willing to push up potential takeover bid prices, then in the short-term, it can slow down stock market activity," he said.

(Additional reporting by Anjuli Davies, Lionel Laurent and Vincent Flasseur. Editing by Jane Merriman)