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Abstract
We show a significantly negative association between changes in financial leverage and contemporaneous risk-adjusted stock returns. The results are consistent with the hypothesis that changes in financial leverage are affected by and, therefore, signal changes in underlying operating performance. Furthermore, we find that changes in financial leverage are also negatively associated with future risk-adjusted returns. We show that changes in financial leverage are correlated with future changes in return on equity, which may partially explain the anomalous pattern in future returns.
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