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

On the one hand, you have gloom-and-doom predictions from luminary economists like Nouriel "Dr. Doom" Roubini, calling an S&P 500 bottom possibly as low as 600 -- more than 20% below yesterday's close.

On the other hand, 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 Burlington Northern (NYSE:BNI) and Ingersoll-Rand.

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 -- exactly 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, author's calculations.
**Returns calculated from 1971-1975.

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 PepsiCo (NYSE:PEP) and Procter & Gamble (NYSE:PG) 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.
  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 currently sits around 0.4% annually, but so long as it doesn't plunge well below zero and remain there -- something even Roubini, the most prominent stag-deflation advocate, doubts will happen -- 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, author's calculations.
**Returns calculated from 1971-1975.

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. Starbucks (NASDAQ:SBUX) has been handling the complex logistics of closing 8% of its more than 7,000 U.S. stores. On the other hand, if tiny Buffalo Wild Wings had to close 8% of its 575 stores and reallocate resources, it could do so relatively easily.

These may also explain why all of the top 30 performers that emerged from the 2001 recession were small or mid caps, including USG, (NYSE:USG), Coach (NYSE:COH), and Research In Motion (NASDAQ:RIMM), which each rose more than 700%.

Small is good
At Motley Fool Hidden Gems, we look exclusively for niche businesses with wide market opportunities and limited analyst coverage. That's where you're going to find the market's best stocks today. So far, our strategy is paying off -- the newsletter service's average pick is beating the broader market.

If you'd like some help finding superior small-cap ideas, you can check out all of our Hidden Gems stock research, as well as our top five small caps for new money now, free for the next 30 days.

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Ilan Moscovitz owns shares of Buffalo Wild Wings, a Hidden Gems recommendation. Coach and Starbucks are Stock Advisor selections. Starbucks and USG are Inside Value picks. PepsiCo is an Income Investor recommendation. The Motley Fool owns shares of Buffalo Wild Wings and Procter & Gamble. The Fool's disclosure policy is the best disclosure policy to read at bedtime.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.