Portfolio Strategy - Sector Rotation

Through my investment journey, I have come across a pretty insightful investment strategy known as sector rotation. Essentially, an investor would increase their allocation to industries that are expected to benefit from the current and subsequent stage of the business cycle, and under allocate to industries that are expected to underperform. This goal of this strategy is to construct a portfolio that will produce returns superior to that of the market.

Fidelity provides a good explanation on the sector rotation strategy and more details can be found in the link here.

A graph on the business cycle from the article is reproduced below. The business cycle is divided into five stages. Stage I-III and Stage IV-V represents expansion and recession respectively.

Various Stages in Business Cycles

The sectors that typically do well in each phase of the business cycle is shown below (which deviates from the sector rotation article by Fidelity)

Stage I - Information and Technology, Properties 
Stage II - Basic Materials and Industrial 
Stage III - Consumer Discretionary and Energy
Stage IV - Utilities and Telecommunications
Stage V - Consumer Staple and Financial

The success of the strategy is predicated on the ability to predict which stage of the business cycle the economy is in and allocate your funds into sectors that will be performing well. So how do we do that? Are there any indicators that can accurately predict the business cycle? 

A possible method is to use the performance of each sector to predict the stage of the business cycle. Lets look at the performance of each sector (for USA) over the past years. As you can see, it is difficult to predict the stage of the business cycle. Judgement and empirical data is often required for prediction.

Sector Performance (Data Source: Vanguard)

 
Based on the actual performance of the sectors, I believe that not all business cycles have five phases. Some cycles have mild recoveries which means there are only Stage I and II. Some recessions are mild in nature, which means they go through Stage IV then proceed to Stage I.

For 2014, I believe that the US economy will remain at Stage III - IV. Hence, the following sectors will outperform the rest.

1) Energy
2) Utilities 
3) Consumer staples