A Pair Trade in Insurance

I have identified another statistical pair trade that looks interesting. The trade would involve buying Allstate (ALL) and selling short Travelers (TRV) in equal dollar amounts. The historical relationship is depicted below; I used the statistical software at CTS Trend:

TRV / ALL 500 days CTS Trend

As you can see, for many years the relative pricing relationship of ALL and TRV was rather stable -- the ratio of the stocks' relative performance hovered near the 1.0 mark. The financial crisis tore apart the historical pricing relationship and created a relative distortion, which can be seen on the right part of the graph. Slowly the prices of these two stocks are converging upon the historical mean ratio of 1.219. It now stands at 1.792. The next target ratio would be at one standard deviation over the historic mean, which equates to 1.606. If that is achieved, then I believe that mean reversion will be accomplished.

On a fundamental basis, ALL is selling at an estimated 6 times fiscal 2009 estimates while TRV is selling at an estimated 8 times fiscal 2009 consensus. This disparity could account for the disjunction of the historical pricing relationship. Thus, on a value basis one could also argue that ALL is cheap relative to TRV.

Of course, risks remain. The insurance industry is still embroiled in the financial crisis and either company could produce positive or negative earnings surprises. As always, the ability to maintain a short position has its limitations and the financial stocks have had borrowing supply or regulatory restrictions during the past few months.

As always with these paired trades, one must remain patient.

Finally, as a follow-up to an old pair trade, I have unwound our long iShares Investment Grade (LQD) ETF vs. a short in the iShares Barclays 20+ Year Treasury Fund (TLT). The trade unwind took place a few days ago at a net spread of 9.50. I recently suggested unwinding at least part of the trade on June 5. I hope you followed me along for that pair trade. (I still own LQD, but not as part of the pair.)

Long ALL, LQD; short TRV

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At the time of publication, Rothbort was long ALL and LQD and short TRV, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. He also is the founder and manager of the social networking educational Web site TheFinanceProfessor.com.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.