Battered home builders in the U.S. got even more bad news Wednesday: new-home sales fell unexpectedly in May, showing the sector must continue searching for stability as it limps through the worst downturn in generations.

Single-family sales decreased 0.6% from the prior month to a seasonally adjusted annual rate of 342,000, the Commerce Department reported. That's below the 360,000 economists had expected.

Year-over-year, new-home sales were 32.8% lower than the level in May 2008.

"The numbers are not great; there's no question about it," said Leif Thomsen, chief executive of independent mortgage lender Mortgage Master.

Still, the results didn't drag down builder shares, which opened with gains aided, in part, by a Mortgage Bankers Association report that mortgage applications filed last week rose 6.6% sequentially on a seasonally adjusted basis, and climbed 17% from the same week a year ago. All the major builders recently showed gains, with Lennar's (LEN) 7.75% gain leading the pack. The Dow Jones US Home Construction Index recently climbed 2.34%.

That's a modicum of good news for an industry that's been struggling for some time. Mounting foreclosures, which can sell for steep discounts, continue to catch buyers' eyes, trumping such builder incentives as paid closing costs and lower mortgage rates for a loan's life. And an $8,000 federal tax credit for first-time qualified buyers until Dec. 1 hasn't driven the deals the industry had hoped it would. Interest rates are ticking upward, sending fresh chills across the industry.

Plus, there's newly enacted appraisal guidelines that some consider stringent, which could "mean that many orders signed in recent months may not result in closings," noted Credit Suisse analyst Dan Oppenheim, who expects further declines in new homes sales in the coming months.

Such issues are why, after climbing for two consecutive months, the monthly National Association of Home Builders/Wells Fargo Housing Market Index dipped 1 point to 15 out of 100 in June.

Sales weren't the only potential disappointment in Wednesday's data. The median price for a new home fell 3.4% in May to $221,600 from $229,300 in May 2008, but was above April 2009's $212,600. Builders have shaved prices - sometimes into the six-digit range - to move inventory. They're now building smaller and cheaper homes.

Oppenheim pointed out the data tends to be biased by mix and prone to revision. "Our market checks continue to indicate much more severe declines," on a year-over-year basis, he said.

At May's end, there were an estimated 292,000 homes for sale, down from the 299,000 for sale at the end of April. But the ratio of houses for sale to houses sold in May remained high, at 10.2. It was 10.4 in April. That's "twice what a normal solid market is," Thomsen said.

And JP Morgan analyst Michael Rehaut expects inventory to remain highly elevated over the next 12 months, which should drive further home price declines and large impairments well into this year.

"We continue to believe demand remains relatively weak, and that a trough in the housing market remains elusive," he said.

-Dawn Wotapka; Dow Jones Newswires; 212-416-2193; dawn.wotapka@dowjones.com

(Jeff Bater and Shara Tibken contributed to this story.)