Last week I was offered this glib investment advice from a retiring real-estate developer who is getting ready to diversify a part of his holdings into common stocks.

He revealed that his past attempts at making money in the stock market had proven fruitless — acknowledging that the Coffeehouse philosophy might be a better approach this time around.

Which way are you leaning on this topic? Is it time to get out of the stock market, jump back in, or sit tight and hold on for dear life? Will Microsoft continue its recent rally? Will Cisco revisit a price of 80 in our lifetime? Is the rally in the Nasdaq index a sign that last year’s crash is over, or is this a small up-tick on its continued slide to a price level of 1000 and lower?

Half of Wall Street’s stockbrokers are telling you it is time to buy. “Technology stocks have gotten hammered — now is the time to sift through the wreckage for some basement-level bargains and prepare for the next bull market.”

The other half of Wall Street is telling you to hold on for dear life. “I know your blue-chip stocks are off 30 percent, but you own great companies in leading industries, and they will come back if you just give them time.”

Then there are the doomsayers who are advising investors to sell everything. “The stock market is still overvalued by any historical measure, the economy is slowing, and we are due for a recession anyway. Get out NOW before it’s too late.”

Before deciding whether to get in, get out, or just sit tight, let’s look at some of the factors that drive stock prices, today and for the next twenty years. One thing is certain, the decisions you make today will have a significant impact on your financial well-being twenty years out.

When analyzing the returns of common stocks, there are two components that drive prices — the speculative and fundamental.

On the fundamental side, over the long haul stock prices will grow at about the same rate as the earnings growth rate of the underlying companies. Absent any speculative influence, the P/E (price to earnings) ratio should remain fairly constant over time. Both the numerator and the denominator of the P/E equation are growing at the same rate.

Over the short-term, it’s a different story. Fundamentals take a back seat to the speculative, or anticipatory impact investors place on a company’s future earnings growth. If the P/E ratio of a basket of stocks increases, it means that the stock price (the numerator) is growing faster than the underlying earnings (the denominator). Let’s look at this scenario in real life.

At the end of 1994 the P/E ratio of the S&P 500 index stood at approximately 15. Over the next five years, this index generated eye-popping returns of 37, 23, 33, 28, and 21 percent respectively. By year-end 1999 the P/E ratio stood at 31, double its 1994 level.

Stock market experts were quick to offer all types of explanations — new computers, new technologies, new economies, etc. — for this unprecedented stock market run and doubling of the P/E ratio.

You can make of it what you want, but it is hard to ignore the obvious — at least within the Nasdaq and S&P 500 indices, stock prices (the speculative) grew at a much faster rate than corporate earnings (fundamentals).

Today, even after last year’s decline, the P/E ratio of the S&P 500 index still stands at 23, almost fifty percent higher than its 1994 levels. What are the scenarios that might happen with the P/E ratio at this historically high level?

In the short term, the speculative impact could return, stock prices could increase dramatically, and the P/E ratio could resume its ascent to 31 and higher. Over the long haul, a much different scenario is likely to occur. Either the S&P 500 stocks will incur a decline (40-50 percent) in value to a point where the P/E ratio is at more historical levels, or, because investors are now paying substantially more for the same dollar of earnings, future returns generated by large growth companies of the S&P 500 index will necessarily be lower.

What to do? It doesn’t matter if you own a portfolio of the greatest companies in the world — it is time to diversify! If all your common stock investments are in blue-chip companies trading above a 25 P/E ratio, it is time to reevaluate whether the short-term speculative rewards are worth the immediate downside risk or the long term risk of holding a sector that offers returns on par with corporate bonds.

Consider diversifying into other areas of the stock market of small, value, and international stocks, REITS and include a healthy dose of fixed income investments to anchor your portfolio.

For investors who are intent on building a successful portfolio for the long haul, the challenge is not to figure out all this financial mumbo jumbo of P/E ratios and the like, the challenge is diversify your holdings beyond a one basket portfolio of high priced blue-chip stocks, allowing you to ignore Wall Street and get on with your life in the process.

(Editor’s Note: Bill Schultheis is the publisher of The Coffeehouse Investor, a financial and investment newsletter. He may be reached at (206) 286-0376 or WjS6@aol.com.).