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Homebuilders rallied on Wednesday as the latest data from the housing market once again confirmed a recovery, albeit from a depressed level.

Shares of homebuilders KB Home (KBH), PulteGroup Inc. (PHM), D.R. Horton Inc. (DHI), Hovnanian Enterprises Inc. (HOV), Toll Brothers Inc. (TOL) and Lennar Corp. (LEN) rallied on Wednesday as investors cheered the latest housing market data. The Standard & Poor's Supercomposite Homebuilding Index gained 3.1% on Wednesday.

On Wednesday, data released by the National Association of Realtors showed that purchase of existing homes rose 7.8% to 4.82 million annual rate in August, the highest level since May 2010.

Meanwhile, a report from the Commerce Department showed that construction of single family homes rose 5.5% to 535,000 annual rate in August. Building permits for single-family homes, which are indicators of future construction activity, rose 0.2% to a 512,000 annual pace in August, which is the highest level since March 2010. Overall, housing starts rose 2.3% to 750,000 annual rate in August.

Earlier in the week, data from the National Association of Home Builders showed that sentiment among homebuilders rose to 40 in September from 37 in August, the highest level in six years. Although reading below 50 suggests negative sentiment about the housing market, it is the homebuilders' outlook that indicates the recovery in housing market will continue. Homebuilders' outlook for sales in the next six months climbed to 51 in September.

Although the housing market remains at a depressed level, there is no doubt that a gradual recovery is taking place. And this recovery has helped homebuilders post significant gains for the year. YTD, LEN has gained more than 84%, KBH has gained more than 95%, PHM has gained more than 160%, DHI has gained more than 76%, HOV has gained more than 165%, and HOV has gained more than 78%. The big question is: after posting such significant gains this year, do homebuilders have further upside potential? I think they do.

Many might argue that homebuilders have peaked and a sharp correction is on its way. But I would not agree with that. Remember that the gains have come even as the housing market, although recovering, is still at a depressed level. More importantly, I believe that the recovery is sustainable and therefore there is still same profit to be made on homebuilders.

Why do I believe that the recovery is sustainable? For a number of reasons: Firstly, sales of new and existing homes have been increasing over the last year. Home prices have also been increasing on a more consistent basis. The supply of homes is shrinking, while sales of distressed properties have eased. Add to all these the record low mortgage rates.

And all this is without taking into account the Federal Reserve's plans to buy $40 billion of mortgage-backed debt each month. The Fed's move is likely to accelerate the recovery in housing market.

Patrick Newport, an economist with IHS Global Insight, doesn't expect a complete recovery in home construction before 2016. But Newport expects the turnaround will continue next year. Even after considering Newport's cautious optimism, homebuilders look attractive.

Sales at U.S. homebuilders are expected to remain on an upward trajectory. A peek at the most recent backlog data of homebuilders further confirms that sales will remain strong in the future. At the end of May 31, 2012, KBH had a backlog 2,962 homes, representing an increase of 22% over the same period in the previous year. Backlog value at the end of May 31, 2012 stood at $693.4 million, representing an increase of 38% over the same period in the previous year.

The story is more or less similar at other U.S. homebuilders. So, there is no doubt the housing market recovery is sustainable and homebuilders, even after posting significant gains for the year, look attractive.

The next big question is how much upside potential do homebuilders have from current levels? The housing market peaked in April 2006. Between April 7, 2006, the peak of the housing market, and September 19, 2012, PHM has fallen more than 59%, DHI has fallen more than 34%, LEN has fallen more than 39%, HOV has fallen more than 91%, and KBH has fallen nearly 80%. TOL has gained 6% in the period. If housing market recovers to 2006 level, then homebuilders mentioned above, except TOL, still have significant upside potential from current levels. TOL, not surprisingly, also has the highest P/E ratio (68.02) among homebuilders. The industry average is currently at 14.23.

I believe that any pullback in homebuilders' shares should be seen as a buying opportunity right now. And homebuilders are just one way to profit from the housing market recovery. I would also recommend looking into home improvement retailers such as Home Depot Inc. (HD) and Lowe's Companies Inc. (LOW), and building materials distributor USG Corp. (USG). USG has fallen more than 75% since April 2006.

Source: Profit From A Recovery In The Housing Market