Avoid Getting Burned by Solar Stocks

Solar stocks are in a "fad" phase. They were white-hot performers for most of 2007 in terms of huge performance, and there were a lot of initial-public offerings chasing that performance. At the start of 2008 they are, collectively, getting crushed. (First Solar's(FSLR Quote) earnings report is helping the sector today, but many of the stocks are still well off year-to-date.)

One common aspect of navigating equity markets over time is how to recognize, deal with and possibly trade fads. Fads can pertain to subsectors or to individual stocks; remember Comparator Systems, a.k.a. IDID, or Andrea Electronics from 15 years ago? There will always be fads coming and going. Some will go quietly, like IDID, but some will pull a lot of people down with them, like many of the Internet stocks at the beginning of this decade.

Click here for larger image.

Fads appeal to our emotions. The fact is, many of the fads are life-changing -- or at least have big impacts on us. I would say the utility of the Internet has at least lived up to its billing of 12 years ago, and probably exceeded it. The Net has changed the way we do almost everything. The impact on society was right but the stocks were not.

This is where we may be now with the solar-stock fad. Despite the failed excitement about solar in the early 1980s, I believe we are at a point now where solar power is on the verge of having an impact -- but I have no idea what that means for any of the stocks.

The solar theme also has some crossover to the China fad. (I realize and believe the move afoot in China is real but there is a big fad element to the China trade too.) Names like Yingli Green Energy Holding(YGE Quote), like the solar stocks charted above, have been crushed; down close to 50% year to date.

Last year saw at least two other fads: agriculture stocks and dry bulk shippers. Buying into fads is neither bad nor good necessarily, but it does add a lot of volatility to a diversified portfolio. Collectively, the solar names mentioned in this article had five to seven times the standard deviation of the S&P 500.

Owning a stock or two from more than one fad at the wrong time could have dire consequences, even if the positions are moderate in size. If you've never thought about fads in these terms before, it does not take much to recognize a hot sector as a fad because the performance is hot, the need for the product is huge and the stocks are "must-own" names.

These traits are easy to spot, and the nature of stock market cycles is such that adding volatility like this at the end of a cycle is a bad idea. So, if you really want some exposure, make sure it is moderate and that you can live with the consequences of a 50% hit to the position. A better time to take extra risk, relative to your own tolerances, is at the beginning of new bull-market cycle. Even the staunchest bull would concede the bull cycle is long in the tooth.