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?

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

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.

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: iShares JPMorgan USD Emerg Markets Bond

    Learn about the iShares JPMorgan USD Emerging Markets Bond fund, which invests in bonds of sovereign and quasi-sovereign entities from emerging markets.
  2. Mutual Funds & ETFs

    ETF Analysis: SPDR Dow Jones International RelEst

    Learn how the SPDR Dow Jones International Real Estate exchange-traded fund (ETF) is managed and for whom the ETF is most appropriate.
  3. Active Trading Fundamentals

    How Hedge Funds Front-Run Index Funds to Profit

    Understand what front running is, and learn how hedge funds use this investing strategy to profit from the anticipated stock buys of index funds.
  4. Mutual Funds & ETFs

    ETF Analysis: Schwab US Large-Cap

    Discover how the Schwab U.S. Large-Cap exchange-traded fund is managed, the index it tracks and the investors for which it is most appropriate.
  5. Mutual Funds & ETFs

    ETN Analysis: Rogers Intl Commodity Energy Total Return

    Learn more about the Rogers International Commodity Total Return, which is an exchange-traded note that tracks a broad index of commodity futures.
  6. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  7. Mutual Funds & ETFs

    ETF Analysis: ProShares UltraPro Nasdaq Biotech

    Obtain information about an ETF offerings that provides leveraged exposure to the biotechnology industry, the ProShares UltraPro Nasdaq Biotech Fund.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI Europe Financials

    Learn about the iShares MSCI Europe Financials fund, which invests in numerous European financial industries, such as banks, insurance and real estate.
  9. Mutual Funds & ETFs

    ETF Analysis: SPDR S&P Insurance

    Learn about the SPDR S&P Insurance exchange-traded fund, which follows the S&P Insurance Select Industry Index by investing in equities of U.S. insurers.
  10. Mutual Funds & ETFs

    ETF Analysis: SPDR S&P Emerging Markets Small Cap

    Learn about the SPDR S&P Emerging Markets Small Cap exchange-traded fund, which invests in small-cap firms traded at the emerging equity markets.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
  4. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  5. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  6. Lion economies

    A nickname given to Africa's growing economies.
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  3. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  4. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  5. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  6. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!