Applied Business Forecasting and Planning

Time Series Decomposition

Introduction

One approach to the analysis of time series data is based on smoothing past data in order to separate the underlying pattern in the data series from randomness. The underlying pattern then can be projected into the future and used as the forecast.

Introduction

The underlying pattern can also be broken down into sub patterns to identify the component factors that influence each of the values in a series. This procedure is called decomposition. Decomposition methods usually try to identify two separate components of the basic underlying pattern that tend to characterize economics and business series.

Trend Cycle Seasonal Factors

Introduction

The trend Cycle represents long term changes in the level of series. The Seasonal factor is the periodic fluctuations of constant length that is usually caused by known factors such as rainfall, month of the year, temperature, timing of the Holidays, etc. The decomposition model assumes that the data has the following form: Data = Pattern + Error = f (trend-cycle, Seasonality , error)

Decomposition Model

Mathematical representation of the decomposition approach is: Yt f ( St , Tt , Et )

Yt St Tt Et

is the time series value (actual data) at period t. is the seasonal component ( index) at period t. is the trend cycle component at period t. is the irregular (remainder) component at period t.

Decomposition Model

The exact functional form depends on the decomposition model actually used. Two common approaches are: Additive Model
Yt S t Tt Et

Multiplicative Model
Yt St Tt Et

Decomposition Model

An additive model is appropriate if the magnitude of the seasonal fluctuation does not vary with the level of the series. Time plot of U.S. retail Sales of general merchandise stores for each month from Jan. 1992 to May 2002.

Decomposition Model

Multiplicative model is more prevalent with economic series since most seasonal economic series have seasonal variation which increases with the level of the series. Time plot of number of DVD players sold for each month from April 1997 to June 2002.

Decomposition Model

Transformations can be used to model additively, when the original data are not additive. We can fit a multiplicative relationship by fitting an additive relationship to the logarithm of the data, since if Yt St Tt Et Then
Log Yt Log St Log Tt Log Et

Seasonal Adjustment

A useful by-product of decomposition is that it provides an easy way to calculate seasonally adjusted data. For additive decomposition, the seasonally adjusted data are computed by subtracting the seasonal component.
Yt St Tt Et

Seasonal Adjustment

For Multiplicative decomposition, the seasonally adjusted data are computed by dividing the original observation by the seasonal component. Most published economic series are seasonally adjusted because Seasonal variation is usually not of primary interest
Yt Tt Et St

Deseasonalizing the data

The process of deseasonalizing the data has useful results:

The seasonalized data allow us to see better the underlying pattern in the data. It provides us with measures of the extent of seasonality in the form of seasonal indexes. It provides us with a tool in projecting what one quarters (or months) observation may portend for the entire year.

Deseasonalizing the data

Fore example, assume you are working for a manufacturer of major household appliances and heard that housing starts for the first quarter were 258.4. Since your sales depend heavily on new construction, you want to project this forward for the year. We know that housing starts show strong seasonal components. To make a more accurate projection you need to take this into consideration. Suppose that the seasonal index for the first quarter of the housing start is .797.

Deseasonalizing the data and Finding Seasonal Indexes

Once the Seasonal indexes are known you can deseasonalize data by dividing by the appropriate index that is:
Deseasonalized data = Raw data/Seasonal Index Therefore
Deseasonalized data 258.4 324.216 0.797

Multiplying this deseasonalized value by 4 would give a projection for the year of 1,296.864.

Deseasonalizing the data and Finding Seasonal Indexes

In general:

Seasonal adjustment allows reliable comparison of values at different points in time. It is easier to understand the relationship among economic or business variables once the complicating factor of seasonality has been removed from the data. Seasonal adjustment may be a useful element in the production of short term forecasts of future values of a time series.

Trend-Cycle Estimation

The trend-cycle can be estimated by smoothing the series to reduce the random variation. There is a range of smoother available. We will look at

Moving Average

Simple moving average Centered moving average Double Moving average

Local Regression Smoothing

Simple Moving Average

The idea behind the moving averages is that observations which are nearby in time are also likely to be close in value. The average of the points near an observation will provide a reasonable estimate of the trend-cycle at that observation. The average eliminate some of the randomness in the data, and leaves a smooth trend-cycle component.

Simple Moving Average

The first question is; how many data points to include in each average. Moving average of order 3 or MA(3) is when we use averages of three points. Moving average of order 5 or MA(5) is when we use averages of five points. The term moving average is used because each average is computed by dropping the oldest observation and including the next observation.

Simple Moving Average

Simple centered moving averages can be defined for any odd order. A moving average of order k, or MA(k) where k is an odd integer is defined as the average consisting of an observation and the m = (k-1)/2 points on either side.
1 Tt k
j m

t j

For example for MA(3)

1 (Yt 1 Yt Yt 1 ) 3 1 T2 (Y1 Y2 Y3 ) 3 Tt

Simple Moving Average

What is the formula for the MA(5) smoother?

Simple Moving Average

The number of points included in a moving average affects the smoothness of the resulting estimate. As a rule, the larger the value of k the smoother will be the resulting trend-cycle estimate. Determining the appropriate length of a moving average is an important task in decomposition methods.

Example: Weekly Department Store Sales

The weekly sales figures (in millions of dollars) presented in the following table are used by a major department store to determine the need for temporary sales personnel.

Period (t) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Sales (y) 5.3 4.4 5.4 5.8 5.6 4.8 5.6 5.6 5.4 6.5 5.1 5.8 5 6.2 5.6 6.7 5.2 5.5 5.8 5.1 5.8 6.7 5.2 6 5.8

Example: Weekly Department Store Sales

Weekly Sales
8

Sales

Sales (y)

0 0 5 10 15 Weeks 20 25 30

Example: Weekly Department Store Sales

Calculation of MA(3) and MA(5) smoother for the weekly department store sales. In applying a k-term moving average, m=(k-1)/2 neighboring points are needed on either side of the observation. Therefore it is not possible to estimate the trend-cycle close to the beginning and end of series. To overcome this problem a shorter length moving average can be used.

Period (t) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Sales (y) 5.3 4.4 5.4 5.8 5.6 4.8 5.6 5.6 5.4 6.5 5.1 5.8 5 6.2 5.6 6.7 5.2 5.5 5.8 5.1 5.8 6.7 5.2 6 5.8

MA(3) 5.03 5.20 5.60 5.40 5.33 5.33 5.53 5.83 5.67 5.80 5.30 5.67 5.60 6.17 5.83 5.80 5.50 5.47 5.57 5.87 5.90 5.97 5.67

MA(5)

5.3 5.2 5.44 5.48 5.4 5.58 5.64 5.68 5.56 5.72 5.54 5.86 5.74 5.84 5.76 5.66 5.48 5.78 5.72 5.76 5.9

Example: Weekly Department Store Sales

Weekly Department Store Sales
8

5 Sales (y) 4 MA(3) MA(5) 3

Week

0 0 5 10 15 Sales 20 25 30

Centered Moving Average

The simple moving average required an odd number of observations to be included in each average. This was to ensure that the average was centered at the middle of the data values being averaged. What about moving average with an even number of observations? For example MA(4)

Centered Moving Average

To calculate a MA(4) for the weekly sales data, the trend cycle at time 3 can be calculated as
y1 y2 y3 y4 5.3 4.4 5.4 5.8 5.225 4 4 or y2 y3 y4 y5 4.4 5.4 5.8 5.6 5.3 5 4

The center of the first moving average is at 2.5 (half period early) and the center of the second moving average is at 3.5 (half period late). How ever the center of the two moving averages is centered at 3.

Centered Moving Average

A centered moving average can be expressed as a single but weighted moving average, where the weights for each period are unequal.
Y1 Y2 Y3 Y4 4 Y Y Y Y T3.5 2 3 4 5 4 T T 1 Y Y Y Y Y Y Y Y T3 2.5 3.5 ( 1 2 3 4 2 3 4 5 ) 2 2 4 4 Y 2Y2 2Y3 2Y4 Y5 1 8 T2.5

Centered Moving Average

The first and the last term in this average have weights of 1/8 and all the other terms have weights of 1/4. Therefore a double MA(4) smoother is equivalent to a weighted moving average of order 5. In general a double MA(k) smoother is equivalent to a weighted moving average of order k+1 with weights 1/k for all observations except for the first and the last observation in the average, which have weights 1/2k.

Least squares estimates

The general procedure for estimating the pattern of a relationship is through fitting some functional form in such a way as to minimize the error component of equation data = pattern + Error The name least squares is based on the fact that this estimation procedure seeks to minimize the sum of the squared errors in the above equation.

Least squares estimates

A major consideration in forecasting is to identify and fit the most appropriate pattern (functional form) so as to minimize the MSE. A possible functional form is a straight line. Recall that a straight line is represented by the equation

Y a bX

Where the two parameters a, and b represent the intercept and the slope respectively.

Least squares estimates

The values a and b can be chosen by minimizing the MSE. This procedure is known as simple linear regression and will be examined in detail in chapter 6. One way to estimate trend-cycle is through extending the idea of moving averages to moving lines. That is instead of taking average of the points, we may fit a straight line to these points and estimate trend-cycle that way.

Least squares estimates

A straight trend line can be represented by the equation

Tt a bt

The values of a and b can be found by minimizing the sum of squared errors where the errors are the differences between the data values of the time series and the corresponding trend line values. That is:

(Y
t 1

a bt )

A straight trend line is sometimes appropriate, but there are many time series where some curved trend is better.

Least squares estimates

Local regression is a way of fitting a much more flexible trend-cycle curve to the data. Instead of fitting a straight line to the entire dataset, a series of straight lines will be fitted to sections of the data.

Classical Decomposition

Multiplicative Decomposition

We assume the time series is multiplicative. This method is often called the ratio-to moving averages method.

Deseasonalizing the data and Finding Seasonal Indexes

First the trend-cycle Tt is computed using a centered moving average. This removes the shortterm fluctuations from the data so that the longerterm trend-cycle components can be more clearly identified. These short-term fluctuations include both seasonal and irregular variations. An appropriate moving average (MA) can do the job.

Deseasonalizing the data and Finding Seasonal Indexes

The moving average should contain the same number of periods as there are in the seasonality that you want to identify.

To identify monthly patter use MA(12) To identify quarterly pattern use MA(4).

The moving average represents a typical level of Y for the year that is centered on that moving average.

Deseasonalizing the data and Finding Seasonal Indexes

Through the following hypothetical example we will see how this procedure works.
Year 1 Quarter 1 2 3 4 2 1 2 3 4 3 1 2 3 4 Time indexY 1 2 3 4 5 6 7 8 9 10 11 12 10 18 20 12 12 20 24 13 14 22 28 16 MA CMA

Deseasonalizing the data and Finding Seasonal Indexes

The centered moving averages represent the deseasonalized data. The degree of seasonality, called seasonal factor (SF), is the ratio of the actual value to the deseasonalized value. That is
Yt SFt CMAt

Deseasonalizing the data and Finding Seasonal Indexes

A seasonal factor greater than 1 indicates a period in which Y is greater than the yearly average, while a seasonal factor less than 1 indicates a period in which y is less than the yearly average. In our example:
SF3 SF4 Y3 20 1.31 CMA3 15.25 Y4 12 0.76 CMA4 15.75

Deseasonalizing the data and Finding Seasonal Indexes

The seasonal indexes are calculated as follows:

The seasonal factors for each of the four quarters (or 12 months) are summed and divided by the number of observations to arrive at the average seasonal factors for each quarter (or month). The sum of the average seasonal factors should equal the number of periods (4 for quarters and 12 for months). If it does not, the average seasonal factors should be normalized by multiplying each by the ratio of the number of periods to the sum of the average seasonal factors.

Deseasonalizing the data and Finding Seasonal Indexes

In our example For the third quarter Seasonal factors are 1.311475, 1.371429. Therefore the average is:
ASF3 1.311475 1.371429 1.341 2

The average of SF for the rest of the quarters is: ASF 0.742063
4

ASF1 ASF2

0.73697 1.144451

Deseasonalizing the data and Finding Seasonal Indexes

The seasonal indexes for the four quarters are:

Year 1 Quarter 1 2 3 4 2 1 2 3 4 3 1 2 3 4 Total 3.964936 4 1.3114754 0.7619048 0.7272727 1.1678832 1.3714286 0.7222222 0.7466667 1.1210191 1.341452 0.742063 0.73697 1.144451 1.353315 0.748626 0.743487 1.154572 SF ASF SI

Finding the Long-Term Trend

The long term movements or trend in a series can be described by a straight line or a smooth curve. The long-term trend is estimated from the deseasonalized data for the variable to be forecast. To find the long-term trend, we estimate a simple linear equation as
CMA f (Time ) CMA a b(Time )

Where Time =1 for the first period in the data set and increased by 1each quarter(or month) thereafter.

Finding the Long-Term Trend

The method of least squares can be used to estimate a and b. a and b values can be used to determine the trend equation. The trend equation can be used to estimate the trend value of the centered moving average for the historical and forecast periods. This new series is the centered moving-average trend (CMAT).

Finding the Long-Term Trend

For our example,The values of a and b are estimated by using EXCEL regression program.
SUMMARY OUTPUT Regression Statistics Multiple R 0.995666021 R Square 0.991350826 Adjusted R Square 0.989909297 Standard Error 0.148571238 Observations 8 ANOVA df Regression Residual Total 1 6 7 SS MS F Significance F 15.18005952 15.18006 687.7079 2.02856E-07 0.132440476 0.022073 15.3125 Lower 95% Upper 95% 13.01814971 13.79137409 0.545094884 0.657286069

Intercept X Variable 1

Coefficients Standard Error t Stat P-value 13.4047619 0.157999932 84.8403 1.81E-10 0.601190476 0.02292504 26.22418 2.03E-07

Finding the Long-Term Trend

The centered movingaverage trend equation for this example is

CMAT 13.40 0.6(TIME)

30

25

20

Y 15 Centered moving average Trend

This line is shown along with the graph of Y and the deseasonalized data.

10

0 0 2 4 6 8 10 12 14

Measuring the Cyclical Component

The cyclical component of a time series is measured by a cycle factor (CF), which is the ratio of the centered moving average (CMA) to the Centered moving average trend (CMAT).
CF CMA CMAT

A cycle factor greater than 1 indicates that the deseasonalized value for that period is above the long-term trend of the data. If CF is less than 1, the reverse is true.

Measuring the Cyclical component

If the cycle factor analyzed carefully, it can be the component that has the most to offer in terms of understanding where the industry may be headed. The length and the amplitude of previous cycles may enable us to anticipate the next tuning point in the current cycle. An individual familiar with an industry can often explain cyclic movements around trend line in terms of variables or events that can be seen to have had some import. By looking at those variables or events in the present, one can sometimes get some hint of the likely future direction of the cycle movement.

Business Cycles

Business cycles are wavelike fluctuations in the general level of economic activity. They are often described by a diagram such as this.

Business Cycles

Expansion Phase: The period between the begging trough (A) and the Peak (B). Recession, or Contraction phase: the period from peak (B) to the ending trough (C). The vertical distance between A and B` provides a measure of the degree of expansion The severity of a recession is measured by the vertical distance between B`` and C.

Business Cycles

If business cycles were true cycles, then

they would have a constant amplitude (The vertical distance from trough to peak). they would have a constant periodicity (the length of time between successive peaks or trough).

Business Cycle Indicators

There are a number of possible business cycle indicators, but the following three are noteworthy

The index of leading economic indicators The index of coincident economic indicators The index of lagging economic indicators

Components of the Composite Indexes

Leading Index

Average weekly hours, manufacturing Average weekly initial claims for unemployment insurance Manufacturers' new orders, consumer goods and materials Vendors performance, slower deliveries diffusion index Manufacturers new orders, nondefense goods Building permits, new private housing units Stock prices, 500 common stocks Money supply, M2 Interest rate spread, 10 year treasury bonds less federal funds Index of consumer expectation

Components of the Composite Indexes

Coincident Index

Employees on nonagricultural payrolls Personal income less transfer payments Industrial production Manufacturing and trade sales

Components of the Composite Indexes

Lagging Index

Average duration of unemployment Inventories to sales ratio, manufacturing and trade Labor cost per unit of output, manufacturing Average prime rate Commercial and industrial loans Consumer installment credit to personal income ratio. Consumer price index for services.

Source: www.globalindicators.org

Business Cycle Indicators

It is possible that one of these indexes, or one of the series that make up an index may be useful in predicting the cycle factor in a time series decomposition. These could be done in

Regression analysis with the cycle factor (CF) as the dependent variable. These indexes or their components may be used as independent variable in a regression model.

Finding the Cyclical Factor

The cyclical factors for our example are:

CMA t CFt CMATt CF3 CMA 3 15.3 1.003 CMAT3 15.2

Year QuarterTime index 1 1 1 2 2 3 3 4 4 2 1 5 2 6 3 7 4 8 3 1 9 2 10 3 11 4 12

Y 10 18 20 12 12 20 24 13 14 22 28 16

CMA CMAT 14 14.6 15.3 15.2 15.8 15.8 16.5 16.4 17.1 17 17.5 17.6 18 18.2 18.8 18.8 19.6 19.4

CF

1.003 0.997 1.006 1.007 0.994 0.989 0.997 1.012

Classical Decomposition

Additive Decomposition

We assume that the time series is additive. A classical decomposition can be carried out using the following steps.

Step 1: The trend cycle is computed using a centered MA of order k. Step2: The detrended series is computed by subtracting the trend-cycle component from the data

Yt Tt S t Et

Classical Decomposition

Additive Decomposition

Step3: In classical decomposition we assume the seasonal component is constant from year to year. So we the average of the detrended value for a given month (for monthly data) and given quarter (for quarterly data) will be the seasonal index for the corresponding month or quarter. Step4: the irregular series Et is computed by simply subtracting the estimated seasonality, and trendcycle from the original data.

The Time-Series Decomposition Forecast

We have seen that, using multiplicative model, a time series data can be decomposed into the product of four components: Yt Tt St Ct Et

Y= The series to be forecast. T= The longterm trend based on deseasonalized data.

It is often called the centered moving-average trend (CMAT) since the deseasonalized data are centered moving averages (CMA) of the original Y values. These are normalize average of seasonal factors that are determined as the ratio of each periods actual value y to the deseaonalized value (CMA) for that period.

S = Seasonal indexes (SI).

The Time-Series Decomposition Forecast

C = The cycle component.

The cycle factor (CF) is the ratio of CMA to CMAT and represents the gradual wavelike movements in the series around the trend line. This is assumed equal to 1 unless the forecasters has reason to believe a shock may take place, in which case I could be different from 1 for all or part of the forecast period.

E = The irregular component.

The Time-Series Decomposition Forecast

We know how to isolate and measure these components. To prepare a forecast based on the time series decomposition model, we must reassemble the components. The forecast for Y (FY) is:
FY (CMAT)(SI) (CF)(E)

Example:Private Housing Start

Example:Private Housing Start

Example:Private Housing Start

The series appears quite volatile The sharp increases and decreases appears to follow a reasonably regular manner, which may reflect a seasonal component. There also appears to be some long-term wavelike movement to the data as well as a slight positive trend.

Example:Private Housing Start

Example:Private Housing Start

The centered moving average series, shown by the solid line, is much smoother than the original series of private housing starts data (dashed line) because the seasonal pattern and the irregular or random fluctuation in the data are removed by the process of calculating the centered moving average.

Example:Private Housing Start

The long term trend in private housing starts is shown by the straight dotted line (PHSCMAT). The dashed line is the raw data (PHS), while the wavelike solid line is the deseasonalized data (PHSCMA). The long-term trend is positive. The equation for the trend line is:
PHSCMAT 237.51 0.313(Time)

Example:Private Housing Start

The cyclical factor is the ratio of the centered moving average to the longterm trend in the data. As this plot shows, the cycle factor moves slowly around the base line (1.0) with little regularity

Example:Private Housing Start

Example:Private Housing Start

The actual values for private housing starts are shown by the dashed line, and the forecast values based on the time- series decomposition model are shown by the solid line.

The Time-Series Decomposition Forecast

Because the time series decomposition models do not involve a lot of mathematics or statistics, they are relatively easy to explain to the end user. This is a major advantage because if the end user has an appreciation of how the forecast was developed, he or she may have more confidence in its use for decision making.