The carnage that ripped through the capital markets last year imparts many lessons, including one people forget when times are flush: Value matters.

One important reason-maybe the main reason-many investors are grieving today over their battered portfolios is that they ignored this sage advice in the bull market that preceded last autumn's collapse. Using company valuation as a guide to managing asset allocation isn't a silver bullet, or course. But if you neglect it, you're almost surely an accident waiting to happen.

Fundamental valuation separates investing from speculation. This is an old idea in the money game, but it's rare that the case is so convincing as now-a time when market history, finance theory and even common sense speak clearly about putting valuation first no matter what the times are, good or bad.

Of course, there's not much appeal in it for those seeking a short-term trading strategy. Indeed, a value-oriented asset allocation framework is likely to shine, instead, over the long haul, as a risk-management tool rather than a return booster. Still, these days that proposition might sound very attractive to a lot of people. Investors have rediscovered that it's essential to smooth out rough edges in the volatility of their investments over a business cycle or two if there's any hope of achieving their long-term financial goals.

The modern incarnation of value investing traces its roots to Benjamin Graham and David Dodd's 1934 Security Analysis, currently in its sixth edition. The book, widely hailed as the value investor's bible, preaches that market prices can (and do) deviate from a security's "intrinsic value" and investors should exploit the gap when the opportunity arises. Buying at a "margin of safety" improves the odds of capturing relatively higher expected returns, the book advises. Meanwhile, it's also critical for the investor to cast a wary eye on assets trading at rich multiples.

Value investing was originally conceived for those picking individual securities, and Warren Buffett and other Graham disciples have put it to good use over the years. Applying those lessons to markets overall, however, is no less compelling these days, in part because of the proliferation of mutual funds and ETFs that target asset classes in broad and narrow terms. Academic literature has also supported transplanting a value-oriented view of investing to asset allocation, and has been moving ever closer to Graham's views since the 1980s.

From a 21st century perspective, modern portfolio theory (MPT) and value investing now share a fair amount of common ground. It's easy to think otherwise, since these two concepts of money management as originally conceived stood in opposition to each other and seemed like natural adversaries.

Modern portfolio theory, after all, spawned index funds and the view that market prices are the best estimate of a security's worth. This idea has always seemed to contradict Graham's value strategy, which asserts that market prices are wrong at times and thus give enlightened investors a chance to second-guess the market and profit from their insight.

What seems to keep the two theories apart is the popular notion of MPT, which remains stuck in the 1960s and 1970s, bogged down by earlier interpretations of the efficient market hypothesis and indexing. By the earlier standards, markets were assumed to be completely unpredictable, according to a strict interpretation of the random walk theory for describing market behavior. In turn, that implied that asset allocation should generally remain static and unchanging, come hell or high water.

But that rift has closed, and a growing body of research in financial economics has more closely seen modern portfolio theory dovetail with the value camp. The two now share some basic assumptions, thanks to the evolution of MPT over the years. It raises the possibility that something akin to a grand unifying theory of investing is at hand.

Should financial advisors care? Absolutely. If the classic strategies of active and passive investing are more closely aligned in favor of value investing than previously recognized, the union lends more authority to a value-informed view of investing strategies generally. This is true for both stock pickers and those using index mutual funds and ETFs to build portfolios.

In other words, we're all value investors now, or at least we all should be. That's the message in the financial literature. A more practical-minded review of market history only strengthens the case.

Consider, for instance, the Boston-based GMO LLC, a value-oriented investment firm that's been warning clients for several years that high market valuations threatened the outlook for equities. Its long-term forecast for ten asset classes published a decade ago now looks unusually prescient. GMO's ten-year outlook for U.S. stocks in 1998 called for a roughly 1% annual loss for the S&P 500 for 1998-2008. The actual performance was essentially flat.

Sage insight, or just dumb luck? No one can say for sure either way, of course. But this much is clear: GMO and other like-minded value shops had been advising clients for several years ahead of 2008 that lofty valuations and unattractive investment prospects were a clear and present danger. So it was hardly rank speculation. Rather, the increasingly cautious outlook among value investors was driven by a pragmatic reading of the fundamentals.

True, the warnings came too early for some investors. Anybody who followed the advice would have had to turn cautious and sacrifice some return at the height of the most recent bull market, one that ran on longer than many thought possible. But in hindsight, it looked like a small price when you consider what happened to the perma-bulls.

One way to look at the market was through the lens of the Tobin's Q ratio, a measure developed by Nobel laureate economist James Tobin that compares a company's market value to its equity book value. In essence, the metric summarizes the current market valuation of a company relative to the replacement cost, or the amount the company would have to pay at the present time to replace any of its assets. Calculating the history of Tobin's Q for the stock market from 1900 to the present reveals a number of major peaks and valleys through the decades.

What stands out in recent years is the Q ratio's unprecedented valuation surge in 2000-which rose to roughly 120% of replacement value, according to calculations by Smithers & Co., a London investment consultancy. Some 20 years earlier, the ratio was bouncing around at roughly 60% of replacement cost. As it turned out, buying stocks in the early 1980s and turning defensive during the late 1990s would have been the best thing an investor could have done.

Indeed, shortly after the 2000 stock market peak there came a severe bear market. When the selling ended in 2002, the market's lofty valuation was sharply deflated, according to the Q ratio. Even so, the market wasn't as cheap as it had been for much of the entire 20th century, so the value crowd remained wary, even as the bulls went into overdrive in 2006 and 2007.

The larger point is that the Q ratio shows what economists call a mean-reverting tendency, so stocks in the aggregate go through periods of undervaluation and overvaluation, just as Graham and Dodd explained in 1934. Alas, in the short term, such signals are of little help. Even over longer periods, it's difficult to estimate future investment returns, which is an inexact science. So the Q ratio, like other valuation metrics, is subject to interpretation and various forms of calculation. Simply put, there's still no crystal ball for making investment decisions. But investors do have a great deal of context in which to make those decisions, if only they would look.

"Value gives you very little guide for what's going to happen in the shorter term," warns Andrew Smithers of Smithers & Co. That said, the Q ratio can be a valuable tool in those rare cases when it's at extreme levels, he says. Such was the case in 2000, when the ratio was screaming of excess valuation in the stock market. At that point, turning cautious looked compelling in real time, based on both the Q ratio and other valuation metrics.

Valuations then dropped to mildly compelling levels in 2002, which arguably set the stage for the multiyear rally that hit the wall last year. Even so, a number of value-oriented strategists warned that equities were still vulnerable, in part because they believed that the late-1990s excesses had only partially unwound in the 2000-2002 correction.

Fast forward to the present, in the wake of 2008's crushing losses, and the Q ratio now tells us that the market is fairly valued, and perhaps even trading at a discount. John Mihaljevic, a CFA and the editor of The Manual of Ideas (ManualofIdeas.com), a Web-based research outfit that publishes several investment newsletters, including Equities and Tobin's Q, estimates that U.S. equities generally have recently been trading at well under replacement cost, based on his reading of the Q ratio. In December, the ratio was at 0.5, which is lower than the historical average going back to 1900. "Longer term," he says. "Tobin's Q at 0.5 is bullish."

Perhaps, but it doesn't guarantee that buying stocks now is a shortcut to profits. Still, it's hard to ignore the apparent relationship between the fundamental measures of equities and investment returns.

Analyzing market fundamentals is a key part of the strategy at the Hussman Funds, a boutique shop that's beaten the odds with an impressive track record so far in the 21st century. The Hussman Strategic Total Return Fund defied the pull of bearish gravity last year by posting a 6.3% total return. Hussman Strategic Growth, on the other hand, took a small hit in 2008, retreating by 9%. Still, even that loss looks impressive in a year when the S&P 500 crumbled by 37%-its biggest calendar year loss since the Great Depression.

At the core of Hussman's investment philosophy is a focus on fundamental valuations. "The value of a security is nothing more than the present value of the stream of cash flows that it will deliver to investors over time," says John Hussman, president and portfolio manager of Hussman Investment Trust. He calls it "the iron law of finance." How does that inform his investment philosophy? "Basically, I look at the prospective return on stocks as a function of their valuation."

It's a principle that finds growing support in the empirical finance literature assessing equities. Consider dividend yields. As the chart shows, there's an apparent connection between the stock market's trailing-12-month yield and its subsequent ten-year return. In other words, higher yields generally foreshadow higher returns. And by that standard, dividend yields have been warning of lower equity returns for some time. It's not a perfect relationship, nor should we expect that yields alone dictate future performance. Nonetheless, it's a productive and arguably essential exercise that investors monitor yields, at least to put them in the context of other fundamental metrics.

Price-earnings ratios also harbor clues about the equity market's outlook, argues Robert Shiller in his book Irrational Exuberance. Surveying more than a century of stock market history, this Yale economics professor finds a robust connection between the market's P/E ratios at any one time and its returns over the following ten years.

Like the dividend yield, valuation levels have also offered clues about future returns, history suggests. That is, high P/E ratios may be followed by relatively unappealing performance and vice versa. "Our confidence in the relation derives partly from the fact that analogous relations appear to hold for other countries and for individual stocks," Shiller writes.

Besides that, the financial literature has identified other variables that hint at what a stock will do: short-term interest rates; the spreads between junk bonds and short-term interest rates; long-term and short-term interest-rate spreads; stock volatility; and book-to-market ratios.

Eugene Fama and Ken French, writing in a 1988 research paper in The Journal of Political Economy, observe that equity returns are "mean reverting" through time. "Our results add to mounting evidence that stock returns are predictable," they advise, albeit with limits. The predictable component of stock returns is, at best, 40% for small-company portfolios looking out by three to five years, the article says. For large-cap stocks, the predictability drops to roughly 25%.

Twenty years after that paper was published, the evidence now that there is at least some predictability in the markets is even broader and deeper. There are still no guarantees, and risk remains alive and kicking, but it's clear that stock price behavior isn't a pure random walk. Markets aren't completely random over, say, three-to-five year periods, economists now recognize. That means market valuations can be analyzed and there can be expectations about medium- and long-term investment horizons.

In coming to understand these issues, researchers have identified a time-varying risk premium for equities. This idea stands in direct contrast to the older belief that it's best to think of the expected equity risk premium as stable and unchanging through time, which implies there should be a constant asset allocation-for example, a mix of 60% equity and 40% bonds. The old wisdom says this mix should remain in place regardless of market conditions-if a pure random walk describes equity price behavior all of the time.

But such a static view of asset allocation no longer fits with the world as we know it. Expectations for the equity risk premium fluctuate. That's not necessarily evidence that the market is inefficient, although some economists-and quite a few investors-think no less than this. Regardless of what a time-varying risk premium says about the efficient market hypothesis, the fact that so many different strands of research have begun to agree on this point suggests that it's based on a fundamental market truth.

The devil, of course, is in the details for designing and managing an asset allocation strategy. Still, we can take some basic lessons from the last 20 years of financial research. Assume, for instance, that one-quarter of the variance in equity returns is predictable, as Fama and French report. That suggests that one-quarter of the equity allocation should be managed dynamically.

Yes, that sounds like market timing. But we should distinguish between trying to speculatively time markets in the short term and modestly adjusting strategic asset allocations according to current market fundamentals. The latter is already widely accepted in fixed-income investing. If you buy a ten-year Treasury note at, say, a 5% yield with the intention of holding it to maturity, the expected return is, of course, 5%. If the ten-year note's current yield falls to 4% a month later, no one bats an eye if investors lower their return expectations and change asset allocations.

Applying a comparable framework for stock allocations, by contrast, is too often dismissed as hopelessly speculative. But that's a misguided view, based on a 21st century reading of market behavior.

"There's a difference between trying to identify short-term direction and trying to identify a prospective long-term rate of return," says Hussman. Bonds as well as stocks, he explains, have a duration (the average date at which the cash flows arrive discounted). Estimating duration for equities is a bit tricky, of course, but it's worthwhile for estimating stock returns for seven years and beyond, he says. "The job of a financial planner is to align the duration of the investments held by their clients with the expected date that those investments will be called on."

A big part of that responsibility for the planner is to consider the duration of equities generally, which means looking at market valuation.

Dynamic asset allocation, as a result, can be justified as managing investment duration to match client liabilities. Some may call that market timing, but 20 years of financial research and the track records of value-oriented money managers suggest otherwise.

True enough, people are quite a bit less confident about projecting returns for equities using dividend yields, P/E ratios, etc. than they are modeling fixed-income performance. But there is plenty of room for conviction in this area, particularly when valuations are at extremes. And to ignore the possibility means ignoring the long arc of financial history.

James Picerno is a freelance financial writer and editor of The Beta Investment Report (BetaInvestment.com).