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Sales of existing homes are released at 10 a.m. EST Monday with expectations for an annualized pace of 475,000, matching last month's report. Last month's release disappointed with a dip of 1.7% from the prior month but still represented growth of 11% year-over-year. Prices for existing homes were also up over 11% from the prior year. As the graph below shows, even with the strong rebound in sales, the seasonally adjusted rate is still well below the average of about 5.5 million homes sold between 1999 and 2003.

An interesting dynamic is building in the housing sector that could help build momentum and surprise on the upside. Lawrence Yun, chief economist for the National Association of Realtors, attributed much of the dip in sales last month to inventory shortages as the supply of housing on the market dropped to a 5.9 month supply. Housing inventory dropped 3.3% last month to 2.3 million homes, its lowest level since March. Despite all the talk of a shadow inventory and overhang of foreclosures, demand is starting to outstrip supply.

Existing Home Sales Chart
(Click to enlarge)

Existing sales data is followed closely with housing starts released Tuesday before the market opens. Starts surprised to the upside last month with a 15% increase to 872,000 on an annualized basis. While multifamily starts have led the recovery, single-family construction has started to pick up in recent months and bodes well for a strengthening market. Single-family permits have been strong as well at a 545,000 annual pace last month and the highest level since July 2008.

The strength in starts last month may mean a slight pullback this month but should not be interpreted as weakness in the market. As in the existing sales data, the recent surge in units sold is still well below the longer-term average. The markets will be looking more closely at the estimated inventory of unsold homes which has dropped steadily to 4.5 months, well off the 6.6 months of supply seen last year. With significantly fewer homes being built and inventory being worked out of the market, price increases could pick up momentum faster than expected.

Housing Starts Chart
(Click to enlarge)

The fact that the housing sector is recovering is no secret. Shares of homebuilders have doubled in the last year and most of the sector is looking fairly expensive compared to historic multiples. While I believe the sector could still surprise on the upside, paying 30 times trailing earnings or more for a stock that has already seen triple digit returns leaves an investor exposed to significant downside risk. Investors need to carefully assess earnings potential and may want to think about pairing stronger names with shorts to hedge headline risk.

Home Improvement

After the homebuilders, home improvement retailers have probably seen the biggest jump in share price. Lumber Liquidators (NYSE:LL) has seen its shares surge by 220% over the last year and now trades for 36.2 times trailing earnings. The company's is profitable with a return on equity of 19.5% and an operating margin of 8.7%, well above peers. The company has grown revenue at an annualized pace of 14% over the last five years and net income at a 23% annualized pace. With a five-year average price multiple of 20 times, the company would have to grow revenue significantly faster over the next year to justify the high current multiple.

Investors may not want to completely neglect the home improvement retailers. The industry will benefit from the rebound in construction as well as improved homeowner sentiment as home prices increase. Against high-fliers like Lumber Liquidators, I like Lowe's (NYSE:LOW) which trades much more reasonably at 21.2 times trailing earnings and pays a 2.0% dividend yield. The shares have lagged peers with an increase of only 37% over the last year but fundamentals remain sound. While lower than Lumber Liquidators, profitability metrics are still respectable with a 5.7% operating margin and an 11.5% return on equity. Lowe's recently announced a partnership with Verizon (NYSE:VZ) to allow customers of the retailer's Iris smart home solution to monitor and control their home systems via their smartphone or tablet.

Timber and Building Products

Despite reporting negative earnings of $0.17 per share over the last year, Louisiana-Pacific (NYSE:LPX) has surged 121% over the period. The company, a manufacturer of building products, has been caught in the frenzy for housing stocks even though it has reported a net loss of $9.52 per share in the last five years. Both operating margin and return on equity are negative and the company pays no dividend. A Circuit Court of Appeals recently ruled against plaintiffs claiming that Louisiana-Pacific negligently designed and manufactured some products and violated provisions under the North Carolina Unfair and Deceptive Trade Practices Act (UDTPA).

A better play in the raw materials space is Plum Creek Timber (NYSE:PCL), a timberland real estate investment trust (REIT). The 15% increase in shares over the last year has increased the price multiple to 36.1 times trailing earnings but sales are expected to increase by 10% this year and next. The company pays a stable 4.3% dividend yield and is relatively well-managed with an operating margin of 15.0% and a 20.5% return on equity. Standard & Poor's recently assigned a BBB senior unsecured debt rating to the company's $325 million in notes due 2023 which will be used to pay debt maturing next year.

Further down the revenue stream

Most of the homebuilders and materials companies have already been bid up and are reaching expensive valuations. Investors may want to look further down the revenue stream to companies that will benefit from a higher rate of household formation and increasing prices.

The Chubb Corporation (NYSE:CB) is a property and casualty insurer that sees approximately 28% of net premiums from homeowners and property policies. The shares trade relatively cheaply at 10.9 times trailing earnings and pay a 2.2% dividend yield. Shares are down 7.1% in the last month on general market weakness and Hurricane Sandy-related selling but are still up 16% over the last year. The company has an 18.7% operating margin and a 12.0% return on equity, both above peers in the industry. The company recently suspended its buyback program to assess losses to Hurricane Sandy.

The housing market has clearly bottomed and the outlook for the next few years may surprise to the upside. The majority of the bounce in stocks associated with the sector has most likely been made already but supply-demand dynamics still offer an opportunity for investors to capture decent returns. Investors should look further out on the revenue curve, possibly to insurance carriers, or hedge relatively cheaper plays against the overvalued names in the sector.

Source: 3 Housing Stocks Yet To Jump And 2 Stocks In Overpriced Territory