* Fund managers dismiss historical metrics in zero rates era
* Relative to bonds, equities still attractive despite risks
* Some investors wary of calling rally's end too early
By Lionel Laurent and Vikram Subhedar
LONDON, May 19 (Reuters) - Investors are clinging to Europe's white-knuckle stock-market boom, betting that the grim economy, zero interest rates and stubbornly low inflation will paradoxically keep driving equities to new multi-year highs.
European stock indices have held onto their lofty perches despite the failure of the euro zone economy to grow as much as expected in the first quarter, defying the repeated trimming of analysts' 2014 earnings expectations.
Several investors said that with official interest rates and bond yields still at rock-bottom levels, they were casting aside doubts over nominal European equity valuations - currently at their highest since 2004 on a price-to-earnings basis - and betting more on the attractiveness of shares compared with the unusually low returns on bonds.
The equity risk premium, which measures stock valuations against the traditionally greater safety of bonds, suggests there is still some juice left in the European equity market, which currently trades bang in-line with its average historical multiple of about 14 times.
"Even if the price-to-earnings ratio for European equities hits 15 ... That may not be enough to stop the rally," said Vincent Guenzi, portfolio manager at Cholet Dupont in Paris.
"Taking the risk premium into account, would it be so shocking to even pay 20 times?"
There is some concern that equities, trading at decade-high valuations, are vulnerable to a pullback given the cuts in economic growth projections in the United States and Europe and mounting risk aversion pushing down bond yields.
Analysts at Goldman Sachs say that equities grinding higher even as bond yields drop is not necessarily incongruous.
Beneath the surface of broader indices, the underperformance of some growth-sensitive sectors and the move back to defensives shows that equities are pricing in some economic weakness, Goldman analysts said in a note.
That sector rotation is keeping indexes up on the year.
There are other factors buoying stock markets: corporate deal-making is supporting valuations and investors looking for yield have latched on once again to dividends. Meanwhile, relative to the United States, the valuation backdrop for European shares appears benign.
A lot depends on how deeply investors are willing to delve into history. On a 10-year time horizon, European stocks appear pricey. On a 30-year horizon, however, they are still some way from hitting the peaks of 23-24 times earnings seen at the height of the dotcom boom in 2000.
Caught in a valuation no-man's land, investors insist that the adjustment to the "new normal" of zero interest rates is currently the key reason for riding out the equity rally, even in the face of a slow-grind economic recovery and some analysts' calls for a summer sell-off.
Traditional valuation metrics simply make little sense on their own in the current environment without taking bond yields into account, said Francois Chaulet, head of Paris-based asset manager Montsegur Finance.
"What is the right price-to-earnings multiple? It's very tough to say," said Chaulet.
"You may have a market that is priced at 15 times earnings but if the benchmark interest rate is near zero...It would not be a stretch to pay 17 or 18 times."
With no clear catalyst in sight to upset the valuation apple-cart, fund managers are also mindful of the risk of upsetting clients if they call a top to the market too soon.
"Fund managers are more worried about exiting a rally too early than they are about exiting it too late," said Yannick Naud, portfolio manager at Sturgeon Capital in London.
"Clients hate it far more when you miss out on a market rise than when you are a victim of a market fall."
One shift in strategy within equities has been to skew more towards low-risk, large-cap European stocks such as French oil major Total or U.K. telecoms group Vodafone as a way to stay invested while also seeking shelter from potential upsets.
Having seen off the worst of the euro debt crisis only two years ago, investors say stock markets are still far from erupting into the exuberance usually associated with market tops.
"The markets are a story of greed and fear," said Cholet Dupont's Guenzi.
"We have just exited fear - we're not yet into the greed." (Reporting by Lionel Laurent and Vikram Subhedar; Editing by Ruth Pitchford)