Now that the focus has shifted from the surprise outcome of the British referendum, market direction is likely to be guided by the Q2 results. The formal commencement of the earnings season is about a week away, but major companies that have already reported are revealing a trend that has a lot in common with the last five quarters.

However, there are some factors working in favor of results this time around. Commodity prices have recovered substantially and forex woes have also receded to a large extent. This is why it makes good sense to pick stocks that are likely to report strong Q2 results and also have strong fundamentals to back them.

Energy, Finance, Tech Likely to Disappoint

Oil prices have posted quarterly gains due to a weaker dollar, fall in the U.S rig count, rise in gasoline consumption and worldwide outages. However, results from energy companies are likely to be the most disappointing and will weigh on Q2 earnings as a whole. According to Zacks estimates, total earnings for the sector’s S&P 500 stocks will fall by 78.9% on a 27.1% decline in revenues.

The other major sectors, which will act as a drag on Q2 earnings, are finance and technology. Q2 earnings for the finance sector’s S&P 500 stocks are projected to fall by 5.8% on a 0.3% decline in revenues. A soft interest rate environment and sliding benchmark treasury yields are the primary reasons for the sector’s woes.

In technology’s case, Apple’s (AAPL) earnings alone will weigh on other stocks from the sector. A 28.4% fall in earnings is expected for the iPhone maker on a 15.2% decline in revenues year on year. This will send the sector’s earnings 4.5% lower despite a 0.4% increase in revenues. 

Why Q2 Could be Better

Second quarter earnings will begin in earnest with Alcoa (AA) reporting on Jul 11. Some S&P 500 companies that have already released results offer a mixed picture. However, a fair conclusion can only be drawn after more companies report earnings. As of now, Zacks estimates for S&P 500 companies indicate that earnings will decline by 6.2% on a 0.7% decline in revenues.

Despite the fact that this could be the fifth successive decline in earnings, an improvement in the current trend could still emerge. This is because of the significant recovery in commodity prices. Additionally, the dollar had declined somewhat during the quarter, which in turn was one of the reasons for an increase in oil prices.

Our Choices

Despite the fact that we are likely to witness another decline in earnings, the overall picture could still improve. This is why it may be prudent to invest in stocks which are likely to post favorable Q2 results.

One could narrow down the list using a positive Zacks Earnings ESP as a guide, along with a favorable Zacks Rank – #1 (Strong Buy) or 2 (Buy).

Earnings ESP is our proprietary methodology for identifying stocks that have high chances of surprising with their next earnings announcement. It shows the percentage difference between the Most Accurate estimate and the Zacks Consensus Estimate.

Our research shows that for stocks with this combination, the chance of a positive earnings surprise is as high as 70%.

HNI Corp. (HNI - Snapshot Report) is an office furniture manufacturer and also manufactures and markets gas- and wood-burning fireplaces.

HNI Corp. has a Zacks Rank #2 (Buy). The company has an earnings ESP of +8.2% and an average quarterly EPS surprise of 20.7%. Its earnings estimate for the current quarter has improved by 8% over the last 30 days.

Reliance Steel & Aluminum Co. (RS - Analyst Report) is a leading metals service center company engaged in value-added materials management and metals processing services.

Reliance Steel & Aluminum has a Zacks Rank #2. The company has an earnings ESP of +2.3% and an average quarterly EPS surprise of 11%. Its earnings estimate for the current quarter has improved by 1.8% over the last 30 days.

AK Steel Holding Corporation (AKS - Analyst Report) is a leading producer of flat-rolled carbon, stainless, electrical steel and tubular products

AK Steel Holding has a Zacks Rank #2. The company has an earnings ESP of +25% and an average quarterly EPS surprise of more than 100%. Its earnings estimate for the current quarter has improved by 37.3% over the last 30 days.

Government Properties Income Trust (GOV - Snapshot Report) is a real estate investment trust (REIT) which invests in properties that are leased to government tenants.

Government Properties has a Zacks Rank #2. The company has an earnings ESP of +1.6% and an average quarterly EPS surprise of 1.3%. Its earnings estimate for the current quarter has improved by 4% over the last 30 days.

Shire plc (SHPG - Analyst Report) is a specialty biopharmaceutical company catering to diverse medical needs through research and development, manufacture, sale and distribution of pharmaceutical products.

Shire has a Zacks Rank #2. The company has an earnings ESP of +8% and an average quarterly EPS surprise of 4%.