What does the recent rise in homebuilding stocks mean?

While the S&P 500 is down by 7% this year, the S&P Homebuilders Sector Spider (XHB) is up by a similar amount. So what gives? Simple bargain hunting or do investors know something we don't?:

Shares of the S&P Homebuilders Sector Spider (XHB), the exchange-traded fund that tracks the biggest publicly traded companies in the residential construction business, have risen 7% this year. That gain is noteworthy on its own, given the 7% decline in the S&P 500.

But what's even more dramatic is the huge rally that erupted in these stocks in the middle of last month, right before the Federal Reserve started cutting interest rates in a bid to stave off a possible recession. The homebuilders ETF is up 29% off its early January lows, while components Toll Brothers (TOL, Fortune 500), Lennar (LEN, Fortune 500) and Hovnanian (HOV, Fortune 500) are up 40%, 52% and 96%.

So after two and a half years of steep drops, have the homebuilding stocks finally seen a bottom? Some investors believe they may have - and that the recent bounce foretells sunnier days for an economy that has been besieged in recent months by recession talk...

The rise of the housing stocks is all the more remarkable given the declining health of the real estate market. The S&P/Case-Shiller 10-city index of house prices dropped 8.4% in November, marking its 11th straight monthly decline. Despite the sliding prices and a recent drop in interest rates, the market for houses remains glutted: The National Association of Realtors said last month that year-end inventory of existing homes for sale amounted to a supply of nearly 10 months at recent selling rates...

The apparent disconnect between stock prices and what's going on in the industry has some observers questioning the bottom call. The skeptics attribute the bounce to factors like short-covering - the process in which investors who had been betting against a stock buy the shares to cover, or close out the trade. Stocks in the homebuilders have been a favorite target of short-sellers, who are counting on falling house prices and a glut of houses for sale to depress demand for new houses and stretch the builders' finances.

"Hedge funds have been told to cut back on leverage," says Ron Muhlenkamp, who runs investment manager Muhlenkamp & Co. in Wexford, Pa., and oversees the Muhlenkamp (MUHLX) fund. Muhlenkamp, who owns shares of homebuilder NVR (NVR, Fortune 500), says the market's swoon in January - a month in which three-quarters of hedge funds lost money, according to one survey - could have accelerated the short-covering, driving homebuilder stocks up further.

Muhlenkamp isn't buying the homebuilders' stocks now for several reasons. First, he believes it won't be possible to get a good read on the 2008 spring selling season for another two months. Muhlenkamp adds that he suspects the rebound of the homebuilders is "more of an '09 story than an '08 story." That's partly because stocks that fall as far as the homebuilders have - Toll Brothers, for instance, has lost a third of its market value over the past year and is down 60% from its July 2005 peak - often need more than one tax-loss selling seasons to fully regain their footing, Muhlenkamp says. That suggests 2008 could bring further declines as investors look to offset other investment gains by selling homebuilder shares purchased at higher prices.

Gordon adds that he expects the government to try to take more action - going beyond the one-time stimulus program President Bush signed this week - to make housing more affordable and more accessible to less affluent buyers. An expanded guarantee program at the Federal Housing Administration, for instance, could significantly increase the pool of possible house buyers, he says. Sweeping action like that could set the group up for a more sustainable gain, Gordon says.

But other market watchers say the bounce in these stocks is already predicting a turn in the homebuilding business.

"Stocks are predictive of the industry about six to nine months ahead of time," says Justin Walters of Bespoke Investment Group in Harrison, N.Y. He says he is bullish on the sector, noting that house-price futures at the Chicago Mercantile Exchange have been forecasting a bottom in house prices in many U.S. markets toward the end of 2008...

Perhaps the most bullish signal comes from the executive suites at homebuilders such as Hovnanian. In a recent post on the Bespoke Investment Group Web site, Walters and colleague Paul Hickey note that a few homebuilder insiders have started buying their own stock - a marked contrast to the heavy insider selling at marquee names such as Toll Brothers that marked the group's 2005 top.

"While some may argue that that homebuilders don't do a very good job building houses," Hickey and Walters write, "one thing they know how to do well is trade their own stocks."