European shares fell on Monday as signs of economic weakness in Europe and Spain's unresolved debt crisis curbed a two-month equity rally, leaving the market exposed to a possible pullback.
Basic resources <.SXPP> and construction material <.SXOP> shares, down 1.8 to 2 percent, led the selloff, which gained momentum after a closely watched survey showed German business sentiment unexpectedly dropped in September.
The reading, hard on the heels of weak purchasing managers' indexes (PMI) last week, was a sign that a European Central Bank pledge to help struggling countries failed to reassure businesses hit by the effects of the debt crisis, which has hurt export markets and sapped investment.
Euro zone banks <.SX7E> also fell, with Spain's Banco de Sabadell down 3 percent, after the Spanish economy minister, Luis de Guindos, said on Saturday the country would not rush to seek a bailout that would pave the way for ECB support on the debt market.
"The rally we had in the last few weeks is very likely not to continue if there's no Spanish bailout request coming," Tobias S. Blattner, director of European research at Daiwa Capital Markets, said.
"The longer we wait, the bigger the potential for equity markets to lose more. Then there is the economic story that continues to be weak, as we saw from the PMIs last week and the Ifo."
He added the euro zone blue chip Euro STOXX 50 <.STOXX50E> index could fall by a double-digit percentage in the coming months if the Spanish debt crisis is not resolved, adding any sustained rally would materialise only if the European economy returned to growth.
The Euro STOXX 50 index, down 1 percent at 2,549.77 points by 1020 GMT, was still up nearly 20 percent since late July, boosted by the prospect of interventions by the ECB and the U.S. Federal Reserve to shore up debt markets and the economy.
The pan-European FTSEurofirst 300 index <.FTEU3> was down 0.5 percent at 1,113.52 points, still within sight of a 14-month high of 1,122.76 hit earlier this month and tested on Friday.
But economic data and earnings momentum have deteriorated in recent months, with downgrades to profit forecasts in the euro zone outweighing upgrades by more than 5 percent in the last three months, Thomson Reuters Datastream data showed.
Andrew Lapthorne, warned the disconnect between share prices and data was bound to hold back equities in the medium term as the effects fade of global monetary stimulus, most notably the Fed's quantitative easing (QE) programme.
"For a while the market will respond to that QE, but eventually over a period of time the fundamentals will just remerge and the market will typically fall," Lapthorne said.
"We've had the QE, but the reality is the economy cycle will probably continue to deteriorate, and therefore you're now stuck between wanting to see what QE does in real economic terms and being confronted by quite poor economic conditions."
He stressed implied volatility was low while share prices were high, suggesting investors would be advised to look for some downside protection.
The Euro STOXX 50 volatility index <.V2TX>, which gauges option prices on euro zone blue chips and is regarded as a measure of investor fears of future share price swings, rebounded 7.3 percent from a six-month closing low hit on Friday.
German IFO and GDP growth:
Graphic of asset returns in 2012:
Euro zone debt crisis in graphics:
(Reporting By Francesco Canepa; editing by Jane Baird)