Homebuilding stocks have had a spectacular run in 2012, rewarding investors who were willing to make a tough contrarian bet when the group was in the dumps late last year. But now, the sector is beginning to look extremely stretched. There could be room for some more upside in a rally that follows a fiscal cliff deal, but otherwise, investors have already wrung out most of the gains they can expect.

This call isn’t based on fundamentals, since the news on that front still looks quite good. Incoming data regarding housing construction and home prices have been exceptionally positive, and homebuilder confidence just registered a six-and-a-half-year high.

What’s more, homebuilders are among the few industries where earnings estimates are rising instead of falling. Last week, Bespoke Investment Group reported that estimates for Q4 year-over-year earnings growth had plunged from 10.2% on Oct. 12 to just 3.7% on Dec. 7. In contrast, major homebuilders such as PulteGroup (NYSE:PHM), D.R. Horton (NYSE:DHI) and Lennar (NYSE:LEN) are seeing rising estimates not just for this quarter, but for 2013 as well. At a time in which earnings momentum is hard to come by, this positive earnings profile has fueled outstanding gains for the home construction industry.

And therein lies the problem.

Homebuilding stocks have risen so far that they are offering investors a much less favorable risk-reward profile than they did a year ago, even when the improving outlook is taken into account.

The first issue is that the gains already in the books are so large that they will be tough to build on in 2013. The Dow Jones U.S. Home Construction Index has tacked on 85.6% year-to-date through Dec. 18, making it the top performer among the 99 industries the Dow Jones tracks. The iShares Dow Jones U.S. Home Construction Index Fund (NYSE:ITB), for its part, is up 155.5% from its low of Oct. 3, 2011.

Alone, this sort of price action alone isn’t necessarily a headwind. From late 2002 to late 2003, for instance, Pulte and Toll Brothers (NYSE:TOL) each doubled, but then went on to more than triple in the next two years before finally topping out. However, at these levels, the sector is no longer cheap. The chart below shows that the price-to-book ratios for the largest names in the group, while still well below their bubble-era highs, are nonetheless far above their post-crisis lows.

The sector still has some positive tailwinds as we move into 2013.

Short interest in the largest homebuilders still is in the 5% to 10% range, which leaves room for short-covering to fuel additional gains. Homebuilders also should continue to benefit from the environment of low interest rates, which makes housing more affordable and offsets the impact of higher credit standards. And not least, the sector provides a pure play on the U.S. economy, insulating investors from the impact of slower growth in Europe and/or China.

Despite these positives, homebuilder stocks now are discounting an ideal scenario in 2013, and anything less than that is very likely to put downward pressure on the group. In a worst-case scenario, a surprising slowdown in growth could lead to significant downside.

In short, there is now much more latitude for the backdrop to deteriorate than there is for it to improve.

A hint of how difficult it is to sustain significant outperformance over two years can be seen in the fate of last year’s top 10 Dow Jones industry performers in 2012. Only one — consumer finance — has cracked the top 40% in 2012.

The Bottom Line

While the key drivers of 2012’s outstanding returns all remain in place for the homebuilders, it will take a continuation of better-than-expected news to drive further gains from here. If you’re not in yet, wait for a better price; and if you already own these stocks, use these highs as an opportunity to sell calls or lock in some profits.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.