The Stocks to Own in This Choppy Market

At midday today, the Dow Jones Industrial average sat around 8,400 -- a good 40% off yearly highs. For a while now, financial headlines have been full of scary words like "recession" and "bear market," and they aren't getting any less ominous.

With the fallout of the tech bubble still fresh in our minds -- and the easy-money subprime bubble fresher still -- talk of recessions and bear markets is enough to make even the steadiest investor rethink the contents of his or her portfolio.

The best stocks to own right now
Traditional wisdom posits that when times are gloomy, investors should flock to so-called defensive stocks. Defensive plays are generally large dividend payers operating in health care, consumer staples, and utilities.

By this logic, hunkering your portfolio down in General Mills (NYSE:GIS) and Eli Lilly (NYSE:LLY) -- both good companies -- will protect you from losing your shirt in a bad market. Not only will you get a steady stream of cash payments, but the stock price will be less volatile because people never stop buying things like cereal and pharmaceuticals.

There's a reason conventional wisdom is conventional. While I won't contradict that advice, I'm going to supplement it with some unconventional wisdom: You should be considering small caps.

Why small caps?
If you have a long-term mind-set, small caps make sense, even in tough times. A recent study by Ned Davis Research (as reported in The Wall Street Journal) showed that since 1979, "the small-stock Russell 2000 returned a median 19.6% in the first three months after a market bottom, versus 13.6% for the large-cap Russell 1000."

That outsized figure makes all the more sense once you view the performance of these former small caps since the S&P 500's low point in early October 2002:

Source: Capital IQ, a division of Standard & Poor's.
*In millions.

It works both ways
Small caps aren't just potent coming out of a bad market -- they actually hold up pretty well during bear markets, too. In the last bear market, in fact, small-cap value stocks as a whole greatly outperformed the S&P 500 and other major indexes.

Far from being speculative plays, small caps can stay afloat in a down market and juice your returns coming out of it.

But the sky hasn't finished falling!
We're not telling you to abandon your large caps and switch everything to small caps. For one thing, smaller companies can be more volatile than larger companies.

Diversification is important. But keep in mind that small caps should be a part of any balanced portfolio, whatever the current economic picture. The growth potential of small caps is simply too great to ignore.

So when you're searching the vast universe for good small-cap ideas, look for stocks with high insider ownership, a strong balance sheet, a solid business model, and compelling valuation.

If you'd like to see the small caps we're recommending in today's market, consider sampling Motley Fool Hidden Gems. Since its inception in 2003, the team's picks are ahead of the S&P 500 by nearly 8 percentage points. You can view our top five ideas for new money with a 30-day free trial -- just click here.

This article was first published June 12, 2008. It has been updated.

Todd Wenning can't give you a tab unless you order something. He does not own shares of any company mentioned. Priceline.com and Netflix are Motley Fool Stock Advisor selections. Eli Lilly is an Income Investor choice. The Fool's disclosure policy is your density.