In a fairly rapid time, the solar power industry has been able to tackle two major challenges that threatened to decimate the industry.#-ad_banner-#

First, far much too capacity led to rapidly falling prices, which pushed the industry’s weakest players into bankruptcy and has left a few more of them struggling to stay afloat. Restrained capacity growth has become the theme of 2013, enabling demand to catch up, and prices on solar panels are no longer plunging at a rapid clip.

Second, the steep fall in solar panel prices has pushed this technology a lot closer to “grid parity,” compared to fossil fuels. If natural gas prices had not also plunged as well in recent years, demand for solar would really be booming.

But gas prices have fallen, and it’s unlikely they will spike higher in coming years. Gas drillers will simply boost output any time prices rise, which is OK with an industry that has learned to become profitable with natural gas at $3.50 to $4 per thousand cubic feet (Mcf). Even as gas rallied to $5 per Mcf, solar still couldn’t compete, at least not without government tax credits (that are set to expire in the U.S. in 2016, have been sharply rolled back in Europe and remain firmly in place in China).

Meanwhile, the improving backdrop for solar has kicked off a furious rally, led in part by short sellers who are getting trampled. The average move up from the 52-week low exceeds 500% for this group.

Notably, only First Solar (Nasdaq: FSLR), SunPower (Nasdaq: SPWR), JinkoSolar (NYSE: JKS) and Canadian Solar (Nasdaq: CSIQ) are even expected to be profitable this year.

But clearly these stocks aren’t surging on the prospects of near-term profits. Instead, it’s a newfound belief that solar power, thanks to further equipment price declines, is on its way to major adoption in the U.S. and elsewhere in the coming years.

Yet it’s simply too soon to draw that conclusion. And you can look to Europe for lessons about how long it will be before this technology can stand on its own.

	Duisburg, Germany For all that Europe has invested in solar power, solar still accounts for just 2.6% of total electricity generation.

Billions Wasted
Over the past half-decade, the governments of Germany, Italy and Spain provided massive subsidies to help stimulate demand for solar power. The move made sense in light of the Continent’s energy insecurity. But cash-strapped governments have tired of subsidizing solar, and those consumers (especially in Spain and Germany) that installed solar are now suddenly being hit with hefty monthly fees simply because they own rooftop panels.

As the European Photovoltaic Industry Association (EPIA) recently noted, “In 2011, Europe accounted for 74% of the world’s new PV installations; in 2012 this number was around 55%. In 2013 it is almost certain that the majority of new PV capacity in the world will be installed outside of Europe.” For all that Europe has spent, solar power still accounts for just 2.6% of total electricity generation.

For a bit of context, Europe has installed 70,000 megawatts (MW) of solar power (through the end of 2012), while China (8,000 MW), the U.S. (7,800 MW) and Japan (6,900 MW) are the largest markets outside of Europe. Solar power investors are clearly counting on these three countries to really step on the gas and pick up the slack that Europe has created in this market.

The Short View Vs. Long View
Over the long haul, as solar panel prices keep on dropping, it’s clear that solar may play a very strong role in power production. But the current sector rally ignores the fact this technology is still not ready to stand on its own without subsidies. So investors may be in for a disappointment when they find that these companies don’t deliver robust growth in their top and bottom line in 2014 and 2015. Simply replacing the lost demand from Europe will be challenging enough.

In that context, it’s helpful to focus on the largest players, starting with First Solar. This company’s radical shift, from simply being a producer of thin-film solar panels, to a large project developer has been well received by investors. Shares have risen 50% in the past three months and 150% over the past 12.

Yet periodically, investors realize that this company’s business model shift is leading to lower margins, and the shares hit an air pocket. Merrill Lynch, which has an “underperform” rating and a $40 price target, cautions that “the company is entering a period of reduced profitability as it works to turns its improving cost position into market share and revenue.”

SunPower, which has a $4 billion market value after a stunning rebound this year that saw its shares rise 700% to $32, is also facing profit pressures. Management recently guided investors to expect per share profits of at least $1 in 2014, even though analysts had been modeling for $1.25 a share in earnings per share (EPS). Estimates have since been dropping though it appears they need to come down further. Merrill Lynch, for example, sees 2014 EPS of just $0.59, half the current consensus forecast.

SunPower’s panels are among the industry’s most efficient, but they are also the priciest. And that leaves the company vulnerable to lost market share as major utilities are more squarely focusing on the lowest-cost providers.

SunEdison (Nasdaq: SUNE) is the only major industry player that appears poised for even better days ahead in 2014, as its contracted backlog grows at a fast pace. I profiled this company back in 2012 (formerly known as MEMC Electronic Materials). Back then, I wrote that “SunEdison has been securing a range of long-term contracts for its power output, so it’s been generating modestly positive cash flow.” Since then, the company’s pipeline has grown yet larger, totaling nearly $3 billion in both contracted projects.

That sets the stage for more than $0.50 in EPS next year and roughly $1.25 in EPS by 2015. They key to SunEdison’s success: a solid value to large-scale utilities that sets the stage for long-term purchasing power agreements. First Solar is pursuing a similar niche, but SUNE appears to be the more reasonably valued stock.

Risks to Consider: As an upside risk, these stocks are still heavily shorted, so further short squeezes may ensue.

Action to Take –> There is no question that the solar energy industry is far healthier than before, and faces very bright long-term prospects, especially if the U.S. and Chinese governments get more serious about carbon taxes.  But the current rally shows all the signs of a mania, perhaps aided by short covering. This is an industry to track, and you should be ready to pounce if better entry points emerge after this rally has cooled.

P.S. Are you terrible at knowing when to sell? You’re not the only one. Fortunately, a former trust fund manager created a two-part blueprint that reveals when to sell… and when to buy. It’s been 85% accurate for over four years — and just closed out a 70% gain. Click here to access it now.