Bubble Markets and Back Testing

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I saw a question on the Reddit /r/algotrading forum about back-testing and how much data one “should” use. As far as I am concerned, the only rules are “whatever works”, but within that framework, I do have some rules I follow. Bubble markets and back-testing affect one another profoundly.

When running back-tests on the strategies I build, I don’t test anything prior to January 2, 2009. I don’t go back any farther than that because of my beliefs about the market. (Remember, you don’t trade the market, you trade your beliefs about the market.) What I believe is that we’ve had 4 entirely different markets in the last 20 years, and the only one in which I can perform valid testing is the most recent.

The Internet Bubble Market: 1994-2001

The first market we had was the internet boom period – more accurately called the Internet Bubble – that started around 1994 and ended with the Dot Com Crash of early 2001. In fairness, this was merely the last 7 years of the Great Bull Market that started with Reagan and ended with the reign of Bush II. This was the time when millions of peoples thought they were genius traders because all you had to do to make money was buy some stock. This was also the heyday of the day-trading craze where everyone who could install highspeed data lines in big room could open their “day trading” company and sell seats. Any back-testing that is performed during this period is highly suspect, because the conditions that prevailed in that market simply don’t exist today.

The Real Estate Bubble Market: 2001-2008

The Dot Com Crash led to a wide-spread despair that Happy Days were never gonna Be Here Again. This was clearly unacceptable, so the Fed does what the Fed does best: goose the market. The Fed decided to slash interest rates in order to spur borrowing. That led to the Great Real Estate Bubble that topped out in October 2007 and ended with the collapse of Bear-Stearns in March 2008.

This was the period when any stock that had anything related to “Real Estate” in its name or prospectus exploded off the charts. This was also the period where “financial engineering” gained ascendancy, which also led to the gross over-valuation of financial stocks. Tech stocks were as shunned during this period as they were embraced during the Dot Com Boom. Any back-testing that covers this period is suspect, especially if  it includes real estate, finance or tech stocks. Like the Dot Com Boom period that preceded it, the conditions that existed then do not exist now.

The End of the World As We Know It Market: March 2007-March 2008

The period from March 2007-March 2008 was dominated by the collapse or  near-collapse of all the Too-Big-To-Be-Allowed-To-Fail financial institutions, the bankruptcy of General Motors, TARP and assorted bailout games, and Bernie Madoff’s $50 billion fraud. It was a time of overwhelming panic, when fundamentals were irrelevant and technicals no longer worked. I don’t consider anything that happened during that market to have any bearing on the current market.

The QE/HFT Bubble Market: March 2009-Present

When the S&P500 bottomed out at 666 in March 2009, the Fed resorted to the the only tool they had left: create money out of thin air. That was the advent of “Quantitative Easing” which utterly changed the nature of the market. Vast quantities of brand new cash came pouring into the market by way of the Fed’s largesse. Not only did fundamentals no longer matter, (most of the big financial institutions were technically insolvent during the time leading up to the QE era), not only dud technicals no longer work, but now the high-frequency traders were starting to take over the market.

Due to the advent of QE and the takeover of the markets by HFT, this market is completely unlike any that has come before it. We are now trading in a market where the dominant realities are not earnings or the promise of future earnings, but by the quantity of newly created money flooding in, and the success of competing trading algorithms. The only period that matters is this one. Don’t bother back-testing data prior to March 2009 because it is no longer relevant.

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