The second half of 2006 may very well wind up being the worst six-month period that home builders will see this decade. Home sales continued to slide, and builders pulled back on supply by dramatically lowering permit issuance. While the pace of the new-home inventory increase appears to have peaked, this is likely as much due to a lower rate of new-home supply as to any positive trend in demand, and builders will have a significant backlog of inventory to move once demand conditions finally do improve.

Rising cancellation rates continue to plague home builders, mainly due to customers' inability to sell their existing homes. The resale market has softened considerably, in what appears to be an inversely proportional relationship with the major stock market indices. No matter whether that's a coincidence or a true representation of capital shifting from real estate to equities, the current sunny days of stocks are a stark contrast to the dismally rising inventories of the housing market, and 2006 will come to represent the end of a brief era of amateur short-term real estate investing that may have been more widespread than various data reflected.

What affects builders consequently affects suppliers and manufacturers in the supply chain. Builders have been forced to cut prices, meaning thinner margins, and thus also have been attempting to glean some benefit from lower prices on some commodities due to the reduction in demand. This means manufacturers, suppliers, and distributors will continue to face a lower-demand marketplace that has contracted rapidly over the course of 2006, while at the same time they must deal with builder customers' requests for price concessions. In addition, while builders may see some relief to their pain once demand conditions begin to improve, that improvement is not likely to filter down to their suppliers until a significant portion of the excess inventory on the market has been sold, which means 2007 could be the dark period for the supply chain that 2006 represented for home builders.

To complicate matters, home buying trends are seasonal in nature and tend to slow considerably during the holiday months. Because of this, it is difficult to accurately gauge, based on the last two months of the year, whether conditions are staying the same, improving, or worsening. Builders and suppliers will be looking forward to early spring to see whether home buyers are coming back to the marketplace.

One promising development is the relaxation in mortgage rates over the past several months. This will ease affordability problems, at least marginally, in higher-priced markets, and may woo some buyers who are on the fence back to the bargaining table.

The economy continues to expand at a subdued pace, impacted in part by the slump in housing. Job growth has been moderate, but not spectacular, and inflation does not seem to be an immediate threat. Ideally, these factors would suggest the Federal Reserve is less likely to increase rates in the near future, which should be of some help to housing in 2007. Though the economy grew at a much slower pace in the second half of 2006 and had only weak to moderate job growth, the economy should still be strong enough to act as a foundation for the housing market this year.

–Jonathan Dienhart heads the Published Research Group for Hanley Wood Market Intelligence, a division of ProSales' parent company, Hanley Wood, LLC.