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* 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 toEurope's white-knuckle stock-market boom, betting that the grimeconomy, zero interest rates and stubbornly low inflation willparadoxically keep driving equities to new multi-year highs.
European stock indices have held onto their lofty perchesdespite the failure of the euro zone economy to grow as much asexpected in the first quarter, defying the repeated trimming ofanalysts' 2014 earnings expectations.
Several investors said that with official interest rates andbond yields still at rock-bottom levels, they were casting asidedoubts over nominal European equity valuations - currently attheir highest since 2004 on a price-to-earnings basis - andbetting more on the attractiveness of shares compared with theunusually low returns on bonds.
The equity risk premium, which measures stock valuationsagainst the traditionally greater safety of bonds, suggeststhere is still some juice left in the European equity market,which currently trades bang in-line with its average historicalmultiple of about 14 times.
"Even if the price-to-earnings ratio for European equitieshits 15 ... That may not be enough to stop the rally," saidVincent Guenzi, portfolio manager at Cholet Dupont in Paris.
"Taking the risk premium into account, would it be soshocking to even pay 20 times?"
There is some concern that equities, trading at decade-highvaluations, are vulnerable to a pullback given the cuts ineconomic growth projections in the United States and Europe andmounting risk aversion pushing down bond yields.
Analysts at Goldman Sachs say that equities grinding highereven as bond yields drop is not necessarily incongruous.
Beneath the surface of broader indices, the underperformanceof some growth-sensitive sectors and the move back to defensivesshows 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: corporatedeal-making is supporting valuations and investors looking foryield have latched on once again to dividends. Meanwhile,relative to the United States, the valuation backdrop forEuropean shares appears benign.
A lot depends on how deeply investors are willing to delveinto history. On a 10-year time horizon, European stocks appearpricey. On a 30-year horizon, however, they are still some wayfrom hitting the peaks of 23-24 times earnings seen at theheight of the dotcom boom in 2000.
Caught in a valuation no-man's land, investors insist thatthe adjustment to the "new normal" of zero interest rates iscurrently the key reason for riding out the equity rally, evenin the face of a slow-grind economic recovery and some analysts'calls for a summer sell-off.
Traditional valuation metrics simply make little sense ontheir own in the current environment without taking bond yieldsinto account, said Francois Chaulet, head of Paris-based assetmanager Montsegur Finance.
"What is the right price-to-earnings multiple? It's verytough to say," said Chaulet.
"You may have a market that is priced at 15 times earningsbut if the benchmark interest rate is near zero...It would notbe a stretch to pay 17 or 18 times."
GREED AND FEAR
With no clear catalyst in sight to upset the valuationapple-cart, fund managers are also mindful of the risk ofupsetting clients if they call a top to the market too soon.
"Fund managers are more worried about exiting a rally tooearly than they are about exiting it too late," said YannickNaud, portfolio manager at Sturgeon Capital in London.
"Clients hate it far more when you miss out on a market risethan when you are a victim of a market fall."
One shift in strategy within equities has been to skew moretowards low-risk, large-cap European stocks such as French oilmajor Total or U.K. telecoms group Vodafone asa way to stay invested while also seeking shelter from potentialupsets.
Having seen off the worst of the euro debt crisis only twoyears ago, investors say stock markets are still far fromerupting into the exuberance usually associated with markettops.
"The markets are a story of greed and fear," said CholetDupont's Guenzi.
"We have just exited fear - we're not yet into the greed." (Reporting by Lionel Laurent and Vikram Subhedar; Editing byRuth Pitchford)
