Mispricing and the five-factor model under different market sentiments

A parsimonious two-factor model consisting of the market factor and the mispricing factor (UMO) yields superior performance in explaining average stock returns than the Fama-French five-factor in high-sentiment periods. However, the five-factor model remains a powerful tool in asset pricing during low-sentiment periods. This is due to the relative importance of risk and mispricing in determining stock prices over different sentiment regimes. Thus, market sentiment should be considered when choosing pricing models.