5 Themes in Solar Stock Trading You Shouldn't Ignore

NEW YORK ( TheStreet) -- The seemingly unstoppable rally in solar stocks -- which hit a fever pitch on Thursday, ironically the same day that the U.S. government gave approval for $8 billion in loans for two nuclear power plants -- may not be over.

However, there are a few key solar sector trading rules to keep in mind given the run-up in stocks this year. Here are five ways to think about whether the latest short-term burst in the sector will continue to be a trading opportunity for long-only investors or for shorts to step in and profit from the madness.
  • 1. There are only two sentiments in solar, and there is only enough room in town for one of them at a time: It can only be excessive optimism or excessive pessimism.
  • It's no surprise, then, that given solar stocks were trading as if the industry had died -- it wasn't even possible at the beginning of the year to borrow some Chinese solar stocks that investors wanted to keep shorting -- sentiment turned early in 2012. Tack on top of that the risk-on equities environment with the S&P 500 already up more than 7% this year, and many of the worst-performing stocks in 2011 have been in rally mode, including solar.
  • 2. Optimism about solar demand doesn't equal better margins and profits for publicly traded companies.
  • Solar supporters rant and rave about anyone who can't accept the exponential growth of solar demand annually. There is good reason to be more optimistic about demand in 2012, however, there is still runaway capacity from solar manufacturers that needs to be constrained for a healthier operating environment and supply/demand balance.

    Think of it this way: To say that the technology sector and use of microchips grows exponentially doesn't imply that every semiconductor company will be successful. In fact, the semiconductor space has been littered with failures throughout the history of the tech revolution. It's no different in solar: An industry where demand grows annually is not proof of success for publicly traded companies competing in a crowded, increasingly commoditized space.

    The Chinese solar stocks, led by the three primary solar panel makers, Suntech Power ( STP), Trina Solar ( TSL) and Yingli Green Energy ( YGE), have rallied this year by 90%, 68% and 55%, respectively. LDK Solar is up 60%, too.

    Stocks like Suntech and LDK have been so extensively shorted that a big part of the rally is covering on the part of the biggest solar bears. For an investor that shorted Suntech at $2 earlier this year, the pain has been severe, even if nothing has improved in terms of the long-term earnings power or financial strength of the company.

    Talk to many solar analysts and balance sheet risks still weigh heavily on shares of Suntech and LDK, while the need for consolidation among Chinese solar manufacturers makes it difficult to make a long-term call on any of these companies.

    Trina Solar and Suntech CEOs have recently talked up the demand profile of China, which has helped to fuel the rally on top of other sector reads that demand is going to be better than previously forecast.

    Another reason cited for optimism about demand was the outlook that European solar company REC provided with its results on Wednesday. REC said 2012 demand is expected to shift from Europe to Asia and the U.S. It also stated that there have been "clear signs of reduced capacity in the entire value chain." REC permanently shuttered 50% of its solar wafer and cell production in Norway.

    However, the company also said, "Current pricing puts severe pressure on margins across the industry." And added, "Overall demand outlook for 2012 is highly uncertain."

    REC summarized its 2012 outlook by stating, "Except in silicon, hardly anyone in the industry make profits."

    Deutsche Bank has been leading the charge on behalf of a better demand scenario, and on Thursday, the firm's solar analyst Vishal Shah, said for the second time in 2012 that things are getting better.

    "Recent checks across the solar supply chain indicate further confirmation of preliminary signs of a pick-up in demand," Shah wrote. "Utilization rates are increasing and poly prices could likely increase further in Feb. Demand pickup in multiple markets appears to be the primary driver of recent strength in fundamentals. Tier 1 companies in China, Taiwan and Korea are seeing increasing bookings momentum and as such are currently running at ~100% utilization. Downstream companies in Europe are also seeing rising orders and as such are likely looking to accelerate module deliveries by paying for air freight."
  • 3. Demand improvement occurs because pricing is elastic in solar. Demand goes down and so does pricing, which in turn leads to renewed demand. But too much demand and prices can go up too much and kill the momentum.
  • Prices fell so far and so fast in solar that supply/demand elasticity had to kick in, spurring solar installations in markets where subsidies support project economics. That's occurring, but pricing has stabilized, as opposed to hit a level where companies would again be making money hand over fist.

    There seems to be a backward-looking sense that solar is about to get rich again with another "fourth quarter 2010." That was when pessimism ran high about solar but Italy came out of nowhere to install so much that the industry had its most profitable quarter in recent history.

    Yet what's occurring right now is improving demand as prices stabilize a little bit higher, and that does not suggest runaway profitability and gross margins back in the 30%-range for Chinese solar companies.

    If pricing were to continue straight up and to the left, that might choke off some demand. And keep in mind that while polysilicon, wafer and cell prices have improved, module prices haven't.
  • 4. Another perverse implication of the solar rally is that if solar stocks continue to rally, these companies may head back to the capital markets to raise more capital -- and they need it - and that will once again dilute shareholders.
  • Finally, it all comes down to the technical trade in a sector that has more often than not been the domain of fast money traders.
  • 5. Traders often say it's not worth trading the last 20% downside of a short in solar, and the same can be said of a rally.
  • There are two types of trading in solar -- long-term bets and short-term bets, or put another way, technical bets and fundamental bets. The latest rally probably features all of these cross-currents.

    For a long investor, there may be 20% left to go in this solar rally, but unless you are buying and holding for the 2013-and-beyond time horizon, getting in now based on improved short-term demand seems like a risky decision.

    Solar companies can come out this earnings season and say shipments will improve quarter over quarter, without saying that margins will be any better. This type of commentary could keep solar stocks moving up from here, but it won't mean that trading momentum is sustainable once the reality of capacity growing as fast if not faster than demand sets back in.

    That means for investors lucky enough to buy at rock bottom prices in early 2012, keep your finger near the trigger if you are not willing to hold solar stocks for at least 12 to 18 months and absorb what might be more pain.

    After all, it could be a while before the dust settles and a secular demand upswing in an embryonic sector translates into normalized earnings and sustainable margins for long-term solar stock winners.

    -- Written by Eric Rosenbaum from New York.

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