It is surprising and potentially alarming that financial leverage has been a powerful driver of stock returns during the market rally over the past year. For stocks in the S&P 500, the sector-neutral long-short factor return for debt/equity was 12% since October 31, 2023, with an impressive 2.7 information ratio. In contrast, the ROE and price momentum factors returned 7.7% over this period, with a 1.3 information ratio for ROE and a 0.6 information ratio for momentum.
The chart shows that since the summer of 2018, stocks with higher debt/equity ratios have often outperformed those with lower ratios. However, the debt/equity factor return in 2024 has been notable. The red trend line highlights the increasing strength of this factor over the past five months.
The stock market rally this year has ignored many risks. The performance boost from financial leverage, measured by debt/equity, carries a risk that could be painful in a downturn.
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