Why Solar Stocks Are Popping Today

China has found a solution for it's ailing solar industry. No, it doesn't involve letting companies fail, as I've suggested in the past. The solution is -- drumroll, please -- more subsidies.

China's Xinhua News Agency reported that the Ministry of Finance allocated $1.1 billion to subsidize solar projects, bringing total subsidies for this year to $2 billion. Shanghai Securities News says officials doubled their target for solar installations. And finally, the Ministry of Science and Technology confirmed that it will provide subsidies to 100 solar companies, including Yingli Green Energy (NYSE: YGE) and Trina Solar (NYSE: TSL), to build 2.8 GW of capacity.

The varying reports tell us one thing for sure -- China is trying to fix the supply glut in solar by installing more solar and is using subsidies to make sure that happens.

The market goes nuts
The reaction from the market today may make you think that all of the solar industry's problems have been magically solved overnight. Chinese stocks jumped by double digits across the board on simply the possibility of winning some of this business.

The reaction is understandable in the short term. News like this drives stocks on a day-to-day basis and solar stocks are particularly volatile when news of subsidy increases or cuts come out. But it's also important to keep perspective of what this means for the industry. The report of 2.8 GW of projects being subsidized still wouldn't fill the capacity gap from underutilization at the companies I've listed above, and it doesn't do anything to alleviate negative margins, unless China is going to pay up for panels.

So here's the good news and the bad news for today's announcement, along with how you should react.

The good
Any increase in demand for solar panels is good news; let's get that out of the way right away. Whether you're manufacturing in China, Thailand, or the U.S., it's always a welcome sight to see higher demand for the industry. This will fill some of the gap between supply and demand, which has widened as Chinese manufacturers added supply and Europe reduced demand under tighter fiscal conditions.

China is apparently keen on keeping its solar industry alive and is willing to put government money behind it. That's good for the long-term winners, but that's where the challenge begins.

The bad
The bad news is that this does nothing to change the structural oversupply of solar products in the market. You can fill some of the demand gap, but last year there were 27.5 GW of solar installed worldwide, and GTM Research predicts that this year there will be 31 GW of solar installed globally. This compares to 70 GW of panel capacity in the industry, so 2.8 GW is a drop in the bucket of overcapacity, and that is mainly in China.

This move also does nothing to change the downward pressure on margins felt across the industry. Below is a graph of gross margins of a few of the largest manufacturers in China and all are selling their products at close to or below cost, leading to massive net losses and growing debt loads.

YGE Gross Profit Margin Quarterly data by YCharts

What really needs to happen is a rationalization of a large amount of supply in the industry. In other words, China needs to stop subsidizing its manufacturers and let the weakest ones fail, just like Solyndra, Evergreen Solar, and Q.Cells did in the U.S. and Europe. The gap between supply and demand is simply too large to fill by China alone over the next few years, and its government can't save all of the companies it has built with the billions of dollars it handed out in loans.

Around the world we're seeing subsidies stripped away from solar, which is positive for the long-term health of the industry. This eventually will leave the strongest suppliers to compete with traditional energy sources on a cost per kilowatt-hour basis, just the way it should be. But in China the opposite is happening. Chinese subsidies primarily will help Chinese companies, which only skews the market and leaves the industry in worse health than it would otherwise be in.

Foolish bottom line
More Chinese subsidies have had a huge impact on Chinese solar stocks today but I wouldn't expect the market euphoria to last. These companies are still sitting on huge debt loads from Chinese state-run banks and are losing money hand over fist. Until China begins cutting the subsidies to solar companies, it simply can't build enough projects to fill the immense gap between supply and demand left in the industry.

Today is an incremental positive for solar, but it doesn't mean we should go dumpster diving for stocks. The best companies with the best products and the best balance sheets will still win in the long term.