* Nikkei falls 2 pct at one point, retreats from 5-mth high
* Profit-taking after rally dents Nikkei -analyst
* Technical gauges suggested Nikkei rally was overstretched
* Analysts say Korean tensions likely to cool
* Short-covering helps temper losses
By Masayuki Kitano
TOKYO, Nov 24 (Reuters) - Japan's Nikkei share average dropped 1 percent on Wednesday as North Korea's shelling of a South Korean island the previous day rattled investors and spurred profit-taking after a recent rally.
Market players said Tokyo shares were due for a pull-back after having climbed this month on the back of solid corporate earnings, as well as short-covering and year-end portfolio tweaking by overseas investors.
The Nikkei's rise was starting to look overstretched after it hit a five-month closing high on Monday, when the Nikkei's divergence above its 25-day moving average -- a gauge used widely among Japanese traders -- climbed into overbought territory.
"The market had been overheating, and market players had been looking for a trigger to book profits," said Hideyuki Ishiguro, a strategist for Okasan Securities.
Japanese financial markets were closed on Tuesday for a national holiday but other major stock indexes fell as investors sought safety after the exchange of fire on the Korean peninsula.
South Korea warned North Korea of "enormous retaliation" if it took more aggressive steps, and Asian equities were broadly weaker again on Wednesday, although analysts said they expected the Korean tensions to cool and that their impact on Tokyo shares could prove fleeting.
The Nikkei fell by more than 2 percent from Monday's close at one point, but later trimmed its losses to stand at 10,010.10 down 1 percent, having edged back up above its 200-day moving average near 9,915.
The broader Topix index shed 1 percent to 866.79.
As of Monday's close, the Nikkei's divergence above its 25-day moving average -- rose to 5.5 percent.
Upward divergences of more than 5 percent suggest that stocks are overbought. The last time the divergence was as high as 5.5 percent was back on April 5, the day the Nikkei hit its 2010 intraday high of 11,408.17.
From there the benchmark share averge skidded nearly 18 percent in about two months.
DEFENCE STOCKS RALLY
"The market is cautious about taking risks due to heightening tensions in the Korean peninsula. Also concerns over sovereign risk are building up again after the downgrading of Ireland," said Hiroaki Kuramochi, chief equity marketing officer at Tokai Tokyo Securities.
Ratings agency Standard & Poor's downgraded Ireland's long-term sovereign credit rating and warned that a further downgrade was possible.
"These factors have prompted active selling, but the Nikkei is already gaining some support on short-covering possibly led by overseas hedge funds," Kuramochi said.
"It's early to say that underlying bullish sentiment for Japanese stocks set since the start of the month have reversed completely, but we need to watch the Korean situation closely," Kuramochi added.
Shares of Inpex Corp, Japan's top oil explorer, fell 1.9 percent to 439,000 yen after oil prices slipped on Tuesday, as fears of an escalating euro zone crisis and tensions on the Korean peninsula triggered a rally in the dollar.
But defence-related shares rallied, with Tokyo Keiki Inc, a maker of instruments for aircraft and boats, climbing 5.3 percent to 120 yen.
Trading house Sojitz Corp surged 8.4 percent to 167 yen after it said it has formed a tie-up with Australian mining company Lynas Corp on the supply of rare earth metals, and would announce details of the agreement later on Wednesday.
News of the deal comes one day after Australia promised to be a future long-tem supplier of rare earths to Japan, after shipments of the minerals from China to Japan had stalled amid a spat over disputed islands in the East China Sea. (Additional reporting by Chikafumi Hodo and Antoni Slodkowski; Editing by Edwina Gibbs)