* FTSEurofirst 300 down 0.5 pct, Euro STOXX 50 down 1.1 pct * Italy's stocks sink, debt yields rise as Monti to resign * Focus is back on Italy/Germany bond spread -analyst * Exane strategists remain 'overweight' Italy, Spain By Blaise Robinson PARIS, Dec 10 (Reuters) - European shares fell on Monday, halting a brisk three-week rally, with Italy's benchmark index sinking nearly 4 percent after Prime Minister Mario Monti said he would resign, reviving fears about the country's economy. At 1148 GMT, the FTSEurofirst 300 index of top shares was down 0.5 percent at 1,127.63 points, halting a rally that had propelled it to its highest level since early June 2011. Milan's FTSE MIB index sank 3.7 percent - its biggest one-day drop in four months - with Intesa Sanpaolo losing 6.9 percent, Banco Popolare down 6.8 percent and UniCredit down 6.3 percent. "Every Italian stock is down, and banks in particular are paying a hefty price. The focus is back on the spread," said Riccardo Designori, equity analyst at Milan-based Brown Editore, referring to the spread between the yields of Italian bonds and German Bunds. "If the spread continues to widen, the best trade strategy is to start shorting these stocks. Spanish stocks are also very vulnerable to the return of 'risk-off' sentiment." Short selling - profiting from falling stock prices by borrowing shares, selling them, then buying them back more cheaply - is a popular hedge fund strategy. The spread between 10-year Italian BTPs and German Bunds widened to 360 basis points on Monday, from 325 late on Friday. On Saturday, Monti announced he would quit once the 2013 budget is approved. The news came two days after Silvio Berlusconi's party withdrew parliamentary support for the technocrat government and hours after Berlusconi said he would run for premier again. The news of Monti's resignation also knocked other European banks, with BNP Paribas falling 3.1 percent, Credit Agricole down 3.3 percent and Banco Santander down 3 percent. "The stress is back, we're asking ourselves again: 'which stock has exposure to Italy?'" said David Thebault, head of quantitative sales trading at Global Equities. "Monti is the one who managed to stabilise Italy and stop the contagion from Greece. His surprise resignation brings back the political risk in the equation, something we had forgotten about." Across Europe, the euro zone's blue chip Euro STOXX 50 index was down 1.1 percent, UK's FTSE 100 index down 0.3 percent, Germany's DAX index down 0.5 percent, and France's CAC 40 down 0.6 percent. The Euro STOXX 50 has surged about 25 percent in the past six months, as bold measures unveiled by the European Central Bank to resolve the region's debt crisis have soothed fears of a break-up of the currency bloc. Europe's recovery rally has propelled stock valuation ratios to levels not seen in 2 1/2 years, with the broad STOXX Europe 600 trading at 11.3 times 12-month forward earnings. Despite the sudden return of political tensions in the euro zone, a number of strategists and fund managers remain positive about the outlook for European equities. In a research note on Monday, strategists at Exane BNP Paribas said they remain "overweight" on Italian and Spanish equities, due to improving macro fundamentals and the two markets' superior earnings growth potential. "Italy is generally viewed as the 'safer' peripheral play. Apart from better domestic macro fundamentals, the composition of the equity markets is better too. Northern Italy has a strong industrial base, which can be played through mid-caps," the strategists wrote.