Updated from 1:54 p.m. EST

Homebuilder stocks rallied Tuesday as investors interpreted D.R. Horton's ( DHI) better-than-expected results as a sign of stabilizing fundamentals within the sector.

Horton, the country's largest homebuilder, earned $109.7 million, or 35 cents a share, in the quarter ended Dec. 31. A year earlier, the company earned $310.1 million, or 98 cents a share.

While the earnings were down sharply, the results topped analysts' expectation for a profit of 33 cents a share, according to Thomson First Call.

Horton's top line fell to $2.80 billion from $2.84 billion but exceeded Wall Street's estimate of $2.76 billion.

The beat lifted the stock up $1.27, or 4.7% to $28.40 in recent trading, and gave a boost to other builder stocks as well.

Hovnanian ( HOV) recently was up $1.44, or 4.5%, to $32.91, and Ryland ( RYL) was adding $1.45, or 2.7%, to $55.88. Toll Brothers ( TOL) jumped $1.41, or 4.4%, to $33.72.

The rally could be fueled by a growing investor psychology that fundamentals are stabilizing in the sector.

"People are playing game theory," says one hedge fund manager who closely follows the sector but has sold off most of his positions. "The stocks typically lift six months or nine months prior to a bottom. There is no clear sign of anything getting better on one hand. But fundamentals probably stopped getting worse."

Another buy-side investor says those jumping into the rally are taking a longer-term approach with the builders.

"My view is the guys buying them are not looking at the spring selling season of '07," for an improvement in fundamentals (and possibly not even 2008), says the source, who shorted builders at the end of 2006 but has now covered and is a little less bearish.

He believes investors, instead, are looking far into the future for normal earnings and revenues, betting that the builders aren't likely to go belly-up.

"These are companies in an industry where there are no technological obsolescence issues," he says. "It is a basic industry that will be around. Housing is not going anywhere. At some point the cycle will reverse itself, and the companies will get normal margins."

Goldman Sachs analyst Chris Hussey upgraded the sector Tuesday from sell to neutral on the basis that the "worst may be past, but the housing market remains troubling."

He also upgraded Horton, MDC Holdings ( MDC) and Toll Brothers to buy, calling them "lower-risk companies at this point in the cycle."

Horton, like most other large builders, has been aggressively clearing inventory during the housing slowdown by offering incentives. The company's gross margins, including land sales, fell to 16% in the quarter from 28% a year earlier.

Its profit also was dragged down by $40.9 million of inventory impairments and $36.8 million of land option contract write-offs.

But some market watchers said Horton's margins weren't as bad as expected.

In its conference call, Horton's management cited as a positive the fact that its gross margin on home sales was 18.6% in the quarter (excluding land impairments), which was down "only" 230 basis points from the end of September.

"We're not seeing significant margin deterioration from our September quarter to our December quarter," management said on the call.

Horton said its homes under construction at the end of the quarter totaled 26,000 units, down from a June 2006 peak of 40,000.

New orders fell 23% to 8,771 units from 11,463 in the prior-year period. Sales were down across the U.S.

The homebuilding sector will see another big earnings report after the market's close, when Centex ( CTX) posts its results.

One builder excluded from Tuesday's rally was Florida condo developer WCI Communities ( WCI). WCI said it expects to record a fourth-quarter loss because of higher buyer defaults and significant land impairment charges.

WCI recently was down 64 cents, or 2.9%, to $21.11.

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