2020 and 2021 turned out to be strong years for the stock market despite some challenges like the pandemic and inflation. However, 2022 is shaping up to be a much tougher year.

This isn't surprising as down years tend to follow years with strong returns. Additionally, the Federal Reserve is no longer providing a boost to asset prices with a dovish policy. Instead, it is focused on tightening policy with market participants expecting between 2 to 3 hikes next year. Of course, this is only because it's determined that the economy is strong enough to handle higher rates and that inflationary concerns are outweighing its employment mandate.

Thus, investors will need to be more selective and mindful of risk than in previous years. One component of this is to focus on the stocks and sectors that have favorable valuations and sufficient business momentum. In this category, the homebuilders offer great valuation, impressive earnings growth, and conditions remain favorable.

In fact, macro conditions have improved due to a stronger labor market and household savings that improved substantially in 2020 and 2021. There remains a shortage of inventory, and there is a demographic bulge with Millennials entering their home-buying years. One headwind is likely to be that mortgage rates move higher due to longer-term rates rising due to accelerating growth and inflation. However, these will still remain low on a historical basis and could even catalyze activity if people feel the need to lock-in low rates before they get above the 4% level.

Of course, housing was one of the best performers during the initial months of the pandemic, demand surged due to people moving out of urban areas and into suburban and rural areas. This was also aided by the Fed's aggressive rate cutting which sent mortgage rates to historical lows.

Following these gains, there were doubts over whether this was a temporary, aberrational move or the start of a new cycle. So, many housing stocks have moved sideways over the last year despite impressive earnings growth.

Though its momentum has cooled from these heady days, there's no doubt that the fundamentals for the homebuilding industry continue to remain strong. The latest new home construction figures showed an 11.8% increase from last year and topped expectations. Similarly, the homebuilders' confidence index has been above 80 which is a historically high reading.

With inflation likely to ebb, homebuilders are going to see richer margins, while revenue keeps growing. This combination should lead to earnings growth and multiple-expansion, leading to outperformance for the sector in 2022.