Yes, root filesystems can indeed by encrypted. (http://koeln.ccc.de/~drt/crypto/linux-disk.html
Even though MD5 is a relatively secure algorithm for storing passwords, I beleive that is not what "farhantoqeer" is trying to say. I beleive (pls correct me if i'm wrong) he's trying to secure himself from someone booting the computer using a floppy or CD and then mounting the current Linux ext2/whatever partition. This would bypass any and all passwords that may be set on the now offline partition and give full read/write access to the attacker.
There is no proper way to prevent this other then placing the hardware in secure locations (under lock and key with only the UI devices exposed). If this is not possible, there is no other way to prevent a boot into the system (or for that matter, no way to prevent someone taking out your harddisk and reading the data in another computer). What you can do is place all your important data into an encrypted partition which you can mount yourself when needed. This way, even if someone can access your entire harddisk, they will not be able to read the encrypted data.
Once again, this isn't a sure-shot solution since if someone has physical access to your computer, there's not much you can do to stop him/her (even with encryption). The would-be attacker could simply replace critical system files with his own modified copies that could, for example, record your keystrokes as you mount the encrypted drive thus exposing the encryption key.
Time to invest in one of those Rs. 40,000 rack mounting lock-and-key server casings?