The Best Stocks to Buy in This Market

You're probably getting all sorts of conflicting messages these days.

On the one hand, just months ago you heard gloom-and-doom predictions from luminary economists like Nouriel "Dr. Doom" Roubini, calling an S&P 500 bottom possibly as low as 600 -- roughly 40% below Friday's close. While Roubini has turned less bearish lately, he, and most economists, agree that we're certainly not out of the woods yet.

At the same time, you have the world's most respected investor, Warren Buffett, saying that now is a good time to buy. Buffett is also putting new money to work, buying shares of Johnson & Johnson (NYSE: JNJ) and Union Pacific (NYSE: UNP).

What's a Fool to do?
With so much debate over what has been roundly dubbed "the worst financial crisis since the Great Depression," I wanted to actually look back at how various strategies fared during each of the other financial crises since the Great Depression.

To get started, I turned to trusty data from Ibbotson Associates, a leading authority on investment research. I calculated the historical returns for cash, bonds, and stocks for those who invested the year following the start of each recession -- roughly the point at which we find ourselves today -- and measured the five-year annualized return for each period.

Here are the results:

Recession	T-Bills	Corporate Bonds	S&P 500	Inflation
March 2001-November 2001	2.3%	7.8%	6.2%	2.7%
July 1990-March 1991	4.3%	12.2%	16.6%	2.8%
July 1981-November 1982	8.6%	22.5%	19.9%	3.3%
January 1980-July 1980	10.3%	17.9%	14.7%	4.9%
November 1973-March 1975	6.2%	6%	4.3%	7.9%
December 1969-November 1970**	5.8%	6%	3.2%	6.9%
April 1960-February 1961	3.1%	3.8%	13.3%	1.3%
August 1957-April 1958	2.4%	3.6%	13.3%	1.3%
July 1953-May 1954	1.9%	1%	22.3%	1.5%
November 1948-October 1949	1.5%	1.9%	17.9%	2.2%
February 1945-October 1945	0.8%	1.8%	9.9%	6.6%
May 1937-June 1938	0.1%	3.8%	4.6%	3.2%
August 1929-March 1933	1%	8.1%	(9.9%)	(4.8%)
Average return	3.7%	7.4%	10.5%	3.1%
Frequency of outperformance	8%	38%	54%	NA

*Data from Ibbotson Associates, Salomon Brothers Long-Term High-Grade Index, National Bureau of Economic Research, Consumer Price Index, and author's calculations.
**Returns calculated from 1971 to 1975.

Rule your recession
Three lessons stand out from this data:

1. Stocks outperform bonds and T-bills most of the time, and by large amounts. And remember, these are just averages -- stronger index components like FedEx (NYSE: FDX) and Gilead Sciences (Nasdaq: GILD) did even better than the S&P 500 average the last time around.

2. Unless you need money or plan on investing it, don't park your capital in cash or Treasury bills. If you're bearish enough on stocks to avoid the stock market, history shows that it's much better to be in a diversified batch of long-term, high-grade corporate bonds. For instance, iShares iBoxx Investment Grade (LQD) is an exchange-traded fund that invests in the debt of stalwarts like Wal-Mart (NYSE: WMT) and Altria (NYSE: MO).

3. The only period the S&P 500 lost money was the 1930-1934 deflationary death spiral, when deflation ran a chilling 5% annually. Inflation has turned slightly positive, and so long as it doesn't plunge well below zero for an extended time, investors who are looking to buy a diversified basket of stocks today are well-positioned.

But that's not the whole story
Various studies -- including one of my own -- show that small caps tend to outperform their larger counterparts by a significant margin, particularly in recessions. To confirm this, I ran the numbers once more to include the smallest quintile of stocks:

Recession	T-Bills	Corporate Bonds	S&P 500	Small Stocks
March 2001-November 2001	2.3%	7.8%	6.2%	15.2%
July 1990-March 1991	4.3%	12.2%	16.6%	24.5%
July 1981-November 1982	8.6%	22.5%	19.9%	17.3%
January 1980-July 1980	10.3%	17.9%	14.7%	18.8%
November 1973-March 1975	6.2%	6%	4.3%	24.4%
December 1969-November 1970**	5.8%	6%	3.2%	0.6%
April 1960-February 1961	3.1%	3.8%	13.3%	20.3%
August 1957-April 1958	2.4%	3.6%	13.3%	16.7%
July 1953-May 1954	1.9%	1%	22.3%	23.2%
November 1948-October 1949	1.5%	1.9%	17.9%	11.5%
February 1945-October 1945	0.8%	1.8%	9.9%	7.7%
May 1937-June 1938	0.1%	3.8%	4.6%	10.7%
August 1929-March 1933	1%	8.1%	(9.9%)	(2.4%)
Average return	3.7%	7.4%	10.5%	14.5%
Frequency of outperformance	0%	23%	15%	62%

*Data from Ibbotson Associates, Salomon Brothers Long-Term High-Grade Index, National Bureau of Economic Research, and author's calculations.
**Returns calculated from 1971 to 1975.

Small stocks outperformed T-bills, bonds, and the S&P about two-thirds of the time -- and they did so by a ridiculous margin.

But how much dough are we talking about?
A few percentage points might not seem like much, but remember, these are annualized figures. Here's how much money $1,000 invested and held for each five-year period would be worth today, adjusted for inflation:

Asset	Under the Mattress	T-Bills	Corporate Bonds	S&P 500	Small Stocks
$1,000 Would Be Worth ...	$145	$1,505	$13,602	$77,367	$808,984

The data over 13 recessionary periods and various academic studies reveals a powerful lesson: Small stocks really are the best stocks to consider buying in this market. 

Why are small stocks so great?
There are many reasons for why all of the market's best stocks have been small caps. Among the three most prominent are:

1. Small caps attract less coverage from major brokerage houses and consequently are more likely to be mispriced.

2. Smaller stocks have more opportunities for growth.

3. Smaller companies have the ability to be nimbler in tricky situations.

These may also explain why all of the top 30 performers that emerged from the 2001 recession were small or mid caps, including Marvel Entertainment (NYSE: MVL) and Titanium Metals, which each rose more than 900%.