The housing market in general was hit right in the face this week with two abysmally weak reports on sales. New home sales dropped -12.4% in July while existing sales dropped a massive -27%. Just like with last summer’s cash-for-clunkers auto rebate program, much of the slowdown is payback for the extra sales activity seen during the government’s homebuyer tax credit.

The drop was so severe that even the most stalwart optimists had to pause and revaluate. And that sent stocks to fresh lows in early trading Wednesday.

But then, as if by magic, shares started to levitate — led by, you guessed it, housing stocks. As a group, the iShares Home Construction (NYSE: ITB) gained +3.1%. Individual issue Toll Brothers (NYSE: TOL) gained +5.8% on huge volume after reporting better-than-expected quarterly results.

I think the gains can continue. Here’s why.

Professional lumber traders are actively betting on a rebound in housing construction as the inventory of new homes continues to dwindle. As a result, lumber prices are up more than 19% from their June lows. You can see in the chart above how lumber prices have set up a positive divergence with stock price. According to Tom McClellan of the McClellan Market Report, lumber prices have acted as a leading indicator for stocks lately. There’s no reason to think the gains can’t continue.

There’s more. Stephen Gallagher and his team at Societe Generale note in a recent research report to clients that while “another pullback in sales activity following the expiration of tax incentives” is to be expected, they “continue to see a gradual uptrend in the housing market driven by pent-up demand and high affordability.”

Let’s look at a few quick stats. The U.S. population is growing at about a 1% annual rate, creating 1.4 million new families each year looking for homes. And right now, builders are starting new homes at only a 546,000 annual rate. So far, according to Soc Gen estimates, the cumulative under build of housing relative to demand totals more than two million units over the last few years. Compare that to their 2.5 million overbuild estimate for the housing boom years of 1998 through 2007.

In other words, the housing inventory glut is almost eliminated. In fact, after peaking in the second half of 2006, new home inventories currently stand at an all-time low. This will all translate into resurgent demand for new homes and earnings growth for homebuilding stocks as the last of this boom-era overbuild is worked off and pent up housing demand is unleashed.

Technically, many issues in the sector look very attractive. In the chart above, you can see how the iShares Home Construction has formed a base of support around $10.75 and now looks ready to move up and out of an oversold condition. I recommend high-beta names in the sector that are demonstrating relative strength. Names like Beazer Homes (BZH), Hovnanian Enterprises

(HOV), and Standard Pacific Corp. (SPF) fit the bill.

As of this writing, Anthony Mirhaydari did not own a position in any of the stocks named here. Be sure to check out Anthony’s new investment advisory service, the Edge, which is launching in September. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

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