Sales of new houses fell in September, sending many builders’ stocks lower Wednesday. It seems the market wrote checks based on previous good news from the sector that the economy can’t yet cash.

The US Commerce Department said new-home sales in September fell 3.6% to an annual pace of 402,000. Sales of new houses were forecast to rise to a 440,000 annual rate. Sales of new houses fell 11% in the West and 10% in the South while increasing 34% in the Midwest and remaining flat in the Northeast. Sales of new houses represent about 10% of the market.

From early July to early August, homebuilder stocks surged, including Lennar (LEN), up about 63%, DR Horton (DHI), up about 60%, Toll Brothers (TOL), up about 40%. Investors bet that the nascent economic recovery would boost home construction despite weak fundamentals.

But predictable earnings from the sector still appear to be a few years away. Homebuilder stocks took a hit in midday trading Wednesday. Lennar fell 6.7%, DD Horton fell 4.9% and Toll Brothers lost 3.9%.

Standard & Poor’s homebuilders exchange-traded fund (XHB) -- which includes builders and construction-related companies such as Owens Corning (OC), Universal Forest Products (UFPI), and high-end home products retailer Williams Sonoma (WSM) -- fell 3.2%. Caterpillar (CAT), often viewed as a proxy for the construction industry (see Why Caterpillar's Strength Doesn't Foretell a Housing Rebound) fell 2%.

First-time buyers are lured by low mortgage rates, price cuts, and a tax credit of up to $8,000 if the deal closes by the end of November. Congress may extend the tax credit through March 31, and phase it out over the remainder of 2010. The basic question: Then what? Remember that car sales fell 10.4% when the Cash for Clunkers program ended.

Housing stocks are well off their peaks from the housing boom that topped out in the summer of 2006 as home prices have fallen about 30%. While day-traders and short-sellers may pocket profits, the sector isn’t yet buy-and-hold.

There are signs of the recession easing, but consumer confidence will remain shaky as long as unemployment is high. The US Bureau of Labor Statistics pegged the September unemployment rate at 9.5%, and many analysts believe it will hit 10% before improving. That makes it unlikely that significant numbers of people will buy houses -- especially if the Federal tax break ends next year.

In the last few years, major builders have done a good job of clearing out backlogged inventory and selling off land that was a valuable asset during the boom but quickly became a drag on the balance sheet.

When sizing up housing stocks, keep an eye on the six states that represent the bulk of new construction: Arizona, California, Colorado, Florida, Nevada, and Texas. Then remember that the housing market is often intensely local -- encouraging news in Southern California’s Inland Empire may be offset by so-so news in the San Francisco Bay Area and Sacramento.

Eric Landry, an analyst at Morningstar, says DR Horton has made progress but isn’t out of the woods yet. He writes:
 

As the largest and most diversified -- as well as one of the lowest-cost -- homebuilders, DR Horton has fared better than several other builders to this point in the three-year-plus downturn. It’s generated a large amount of cash, fortified its balance sheet, and disposed of a large amount of high-cost land. Yet there is still work to be done, as an upturn may yet be a ways off and the company is still saddled with what we think is too much inventory.

Lennar shrewdly used joint ventures to reduce the risk of owning land, but the portfolio’s leverage increases risk when home prices fall. In a research report, Landry says: “Shareholders run the risk of having a material amount of debt come onto the balance sheet at a time of extreme industry weakness. That said, management has done an excellent job of reducing exposure from lofty levels of 2006 and 2007.”

Toll Brothers, he says, stands out because it has established a competitive advantage at the high-end of the market: “The company posted its first lost as a publicly traded company last year, and 2009 will be more of the same. Nevertheless, the company will exit the downturn an even more dominant player in its luxury niche.”

Homebuilder stocks again will be attractive, but high unemployment amid continued economic uncertainty and the end of the first-time homebuyers’ tax credit suggest that time isn’t now.