This week's stock market rally lifted long-suffering financial shares and home-builder stocks and was seen as a heartening sign for the battered housing market, although economists say it's only the first, uneasy step toward restoring confidence and an eventual turnaround.

A recovery may still be years away, and several other key factors need to come together before housing prices can stabilize and begin to mend. Interviews with housing and financial analysts revealed several signs that savvy investors might want to look for that would set the stage for a housing recovery.

First, financials stocks such as banks and lenders, as well as other housing sectors such as home builders, need to flatten and rebound.

"The sentiment is so negative," said Mark Vitner, senior economist at Wachovia Corp. (WB, Trade ). "The housing industry isn't going to get better until financial services improve, and there's just too many homes out there in inventory."

The economist said if construction pulls back the next two years as expected, housing supply and demand should get back in balance by the tail end of 2009, considering the glut of unsold homes currently on the market.

Another requirement is that spreads on bond yields need to come down, giving investors a better sense of safety, while the commercial real estate market has to avoid major setbacks. A plan to freeze rates on subprime adjustable-rate mortgages, if it moves ahead, would help quell fears of a surge in home foreclosures, experts said.

The projections for the credit and mortgage markets must brighten, and consumer confidence has to revive. Homebuyers need to come out this spring, but all bets are off if the economy slides into a recession. Finally, more rate cuts by the Federal Reserve in coming months would also improve the outlook, as would consolidation in the home-builder sector or foreign investors putting more money into banking and housing stocks.

First, experts agree the turmoil in credit and mortgage markets needs to settle, giving banks and lenders a chance to get their dented balance sheets back in order.

Also, liquidity must return to the so-called secondary mortgage market where banks bundle together and sell loans in packages called mortgage-backed securities, using the proceeds to fund more loans.

When mortgage markets seized up this summer, investors treated riskier mortgage-backed securities like toxic waste and they became difficult to value, in some cases being viewed as virtually worthless.

Now, some lenders getting cash infusions from investors are seen as a sign that these securities are at least being priced, and that confidence is returning to markets. Tattered lenders need to find capital at a reasonable cost so they can continue to give loans to borrowers.

The market found a glimmer of hope this week from reports that the U.S. Treasury is working with a group of banks including Citigroup Inc. (C, Trade ), Wells Fargo & Co. (WFC, Trade ) and Washington Mutual Inc. (WM, Trade ) on a plan to extend the lower introductory rate on subprime loans that is scheduled to reset higher in coming months.

About $362 billion worth of subprime adjustable-rate mortgages, or ARMs, are slated to reset higher next year after their "teaser" rates expire, according to Banc of America Securities. The rescue measure would provide relief to distressed borrowers and is designed to prevent a surge in foreclosures, which would only add to the inventory overhang and delay a recovery.

"Will the farewell to ARMs end the credit crisis? Not by itself, but it is certainly a move in the right direction," said Ed Yardeni, chief investment strategist at Oak Associates.

"The plan being floated by Treasury to temporarily freeze subprime mortgage rate resets makes compelling sense," wrote analysts at Fox-Pitt, Kelton in a report to clients Friday. "It is a necessary step to stabilize reeling mortgage markets and avoid a further downturn, as servicers struggle to cope with a cascade of current and potential foreclosures."

Markets cheered news of the ARM bailout plan and Friday's rally capped a strong week on Wall Street. Some of the biggest beneficiaries were financials and home-building stocks that have taken the brunt of the damage during the recent correction.

Embattled Citigroup shares also enjoyed a much-needed lift this week after the banking giant got a $7.5 billion cash investment from the Abu Dhabi Investment Authority, and the news boosted financials stocks across the board. Although banks are clearly not out of the subprime woods yet and more write-downs and job cuts may be looming, the foreign investment was seen as a vote of confidence.

"The Citigroup deal is a huge sentiment changer, and gives people bullets they haven't had lately," said Jon Najarian, co-founder of OptionMonster.com, a Web site that monitors trading activity.

"Banks need to continue to clean up their acts and then be ready to facilitate a housing recovery, rather than being a stumbling block," said Anita Clemons, vice president of investments at New Covenant Funds.

Banks are in a dilemma because they have subprime exposure that may have to come onto their balance sheets. That would further squeeze capital reserves and prevent banks from making loans, which would hurt the job market and spill over into housing.

"Even if the stock market goes through brief relief rallies, we haven't seen all the subprime losses yet," said Jim Swanson, chief investment strategist at MFS Investment Management.

Swanson said he's also looking at the bond market and the yield curve. He said the spread between the yields of high-yield bonds and safer Treasury bonds needs to come down. "The high-yield market is showing signs of distress," he said. "The bond market is not saying things are going to get better soon."

Andrew Clark, senior research analyst at Lipper, said the current housing downturn is unlike the most recent pullbacks in the early 1980s and 1990s. This correction has not been marked by surging interest rates or an economic recession, at least yet.

Also, thus far "the commercial side has held up relatively well," said Josh Zegen, managing partner at Madison Realty Capital. "Still, there's not a lot of transparency in the market on future write-offs, and lenders aren't stepping in like they used to." If the market for commercial properties such as offices and apartments worsens, it could crimp any improvement in residential housing.

On the other side of the equation, home buyers have to overcome their fear of taking out a loan on a house that may only end up losing value in the short term.

One of the biggest factors standing in the way of a housing recovery is buyers' lack of confidence in home prices and pessimism that a home will decline further in value after it is purchased, said Don Tomnitz, chief executive of D.R. Horton Inc. (DHI, Trade ) at a recent investment conference. The CEO added that he hasn't seen price stability yet, but that he expects it to be achieved in 2008.

"Consumers' spending and credit in recent years have been boosted by their biggest asset going up -- their home," said Kevin Divney, a portfolio manager at Putnam Investments. "We'll have to see what kind of pain flows through now."

Certainly, additional Fed rate cuts would soothe some of the sting for consumers. Also, a pickup in homebuyer traffic this spring during the sales season would provide a lift and take some inventory off the market, although activity needs to be adjusted for seasonal factors to spot a solid trend. After much hype, the last two spring seasons turned out to be busts.

The builder stocks are another sector that may tip investors off to better times, since they tend to rally before the housing market itself rebounds.

Shares of residential builders have been pummeled this year as the companies have suffered losses and huge impairment charges to write down land values. An exchange-traded fund tracking the industry, iShares Dow Jones U.S. Home Construction (ITB, Trade ), was down about 60% so far this year as of Nov. 28.

Some analysts say the downtrodden sector is a screaming bargain, but investors who've dipped a toe into builders have only found a value trap thus far as the stocks continue to fall.

Meanwhile, more grim data came out of the housing market this past week. In October, the inventory of existing homes for sale reached a 22-year high, and builders cut prices on new homes at the fastest pace in 26 years. Separately, U.S. home prices were falling in every region of the country in September, hitting cities that had been holding up relatively well in the pullback, according to the S&P/Case-Shiller price index.

"There's a huge inventory of unsold homes, and home prices are still high," said Robert Shiller, chief economist at MacroMarkets LLC, in an interview. The housing market is struggling in the aftermath of the "biggest real estate boom we've ever seen," he said.

The depth of the current housing bust has surprised many, but some investors are piling into unloved home-builder stocks in the hope they will be rewarded in the long run.

"The home builders will rally first," said Stephen Kim, an analyst who covers the industry at Citigroup Inc. "The thing that gets them to rally is that the housing situation is less worse than initially feared."

Home builders are among the most-shorted stocks right now and investors are pricing in the possibility of bankruptcy as they focus on balance sheets, liquidity and leverage. Even Kim, one of the more bullish analysts on the group, recently downgraded his near-term outlook on the group. He said it's difficult to time the bottom because the housing cycle hasn't correlated with the economic cycle, and because price cuts in the resale market are lagging far behind the market for new homes, which has already seen significant discounting.

Despite the bloodshed in home-builder stocks, and some smaller, private and Florida-based firms filing for Chapter 11, the sector could get a psychological boost from industry consolidation. Some builders have seen their debt cut into junk territory and have needed to amend their credit facilities with lenders. Judging by recent short-interest levels, those facing the greatest pressure include WCI Communities Inc. (WCI, Trade ), Beazer Homes USA Inc. (BZH, Trade ), Hovnanian Enterprises Inc. (HOV, Trade ) and Standard Pacific Corp. (SPF, Trade ).

"We will see speculation on M&A," said Najarian at OptionMonster. "A deal would be a sign that builders are on the path to recovery."

One scenario would be foreign investors buying a public home builder as a way to own a piece of the U.S. housing market. "That would be my tip-off," Najarian said. "Increased volume and trading in the housing stocks would be a good sign that the bottom is in, and home prices should start to uptick."

Clemons at New Covenant Funds said money managers are looking for a flicker of light in builder stocks, which are still seen as risky even though they're trading at or below book value.

"When we see things start to turn, the builder stocks will move before the earnings recover; that's how they behave," she said.

"We need to wring the excess out of the system, and get housing market expectations to a bottom," said Bob Doll, global chief investment officer for equities at BlackRock Inc. (BLK, Trade ).

"Markets always anticipate, and before we actually see a housing rebound, home-builder stocks will recover," Doll said. "That's the investment dilemma. If you wait for fundamentals to improve, you've missed the stocks' bottom, but you've also removed the risk of catching a falling knife."