Homebuilders have been among the top performers this year, with the iShares Dow Jones U.S. Home Construction ETF (ARCA:ITB) trading up 74% so far this year. Popular homebuilders like Lennar Corporation (NYSE:LEN) and PulteGroup Inc. (NYSE:PHM) have jumped 97 and 173%, respectively. But, will these trends continue or is the sector now overbought?

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Driving Forces Behind the Market
The homebuilding sector has been largely driven by low interest rates and lending standards that are slowly loosening. New housing starts jumped in October to a seasonally adjusted annual rate of 894,000, which is 3.6% higher than September and 41.9% higher than last year, according to the United States Department of Housing and Urban Development and the U.S. Census.

SEE: Top 8 House-Hunting Mistakes

Homebuilder confidence has also been on the rise, after the Housing Market Index surpassed economists' forecasts with a 46 reading - up from 19 a year ago. Builders reported increasing demand for new homes as inventories of foreclosed and distressed properties began to shrink across the U.S., according to one homebuilder cited in the National Association of Home Builders' press release.

Finally, the volume of lumber being shipped on U.S. railroads reached a seasonally adjusted rate of 9,064 carloads per week in October, which was the highest average since November of 2008. There has been a strong historical correlation between housing starts and rail carloads of lumber, wood and forest product, making this a great leading indicator.

Potential Slowdown and Other Risks
Despite these drivers, there are signs that the homebuilding market may be slowing, or at least due for a break. Building permits issued in October fell 2.7% from September, signaling that new construction may not be as bullish in November. Investors should look for any continuations in these trends that could offset the bullishness in the above indicators.

Many homebuilders also appear to be slightly overvalued given their growth rates and the S&P 500's average price earnings multiple of 15.48 times. For example, PulteGroup Inc. trades with a P/E ratio of nearly 41 times earnings and Toll Brothers Inc. (NYSE:TOL) trades with a P/E ratio of over 60 times, which are both sharply higher than the market's average.

Finally, short interest is rising in many homebuilders as speculation mounts that these stocks are running out of steam or are at least due for a retracement. For example, Lennar Corporation reported a short interest ratio of 6.9 times and D.R. Horton Inc. (NYSE:DHI) reported a short interest ratio of 5.9 times, both as of Oct. 31, 2012.

SEE: 5 Must-Have Metrics For Value Investors

Some Are Better Than Others
There are some safer bets in the homebuilding industry for investors interested in taking less risky positions. With a diversified portfolio of stocks, the iShares Dow Jones U.S. Home Construction ETF is perhaps the safest play on the space. The ETF has an expense ratio of just 0.47% and holds a diverse set of stocks, even including home retailers.

Investors looking for individual stocks may want to consider those with relatively low short interest ratios and less exposure to higher land and material costs. Toll Brothers Inc. is an ideal candidate with a relatively low short interest ratio of 3.1 times and is well positioned to take advantage of the homebuilding sector's quick recovery in terms of lower costs.

The Bottom Line
The homebuilding market has experienced a robust recovery in 2012, but that recovery could fade in 2013 as valuations appear lofty and short interest is rising. Investors should keep an eye on leading indicators like housing permits and railcar volumes in order to stay ahead of the curve, while perhaps selectively investing in only strong industry leaders of diversified ETFs.

At the time of writing, Justin Kuepper did not own any shares in any company mentioned in this article.

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