Time Series

Forecasting

Outline:
1. Measuring forecast error
2. The multiplicative time series model
3. Naïve extrapolation
4. The mean forecast model
5. Moving average models
6. Weighted moving average models
7. Constructing a seasonal index using a centered
moving average
8. Exponential smoothing
Forecast error

Forecasting Convenience Store Ice Sales

(1) (2) (3) = (2) – (1)
Forecasted Actual
Month/Year Value Value Error
July 2000 $390 $423 $33

Aug 2000 450 429 -21

Sept 2000 289 301 12

 3 measures of forecast error
• Mean absolute deviation
• Mean square error
• Root mean square error.
 Actual

Predicted

Time
Average Absolute Error (AAE) is given by:
m
1
AAE 
m
Y
t 1
t  Yˆt

Where Yt is the actual value of variable that we seek to

forecast and Yˆt is the fitted or forecasted value of the
variable.
 Actual

Predicted

Time
Mean Square Error (MSE) is given by:
m
1
MSE 
m
 i i
(Y 
t 1
Yˆ ) 2

Where Yt is the actual value of variable that we seek to

forecast and Yˆt is the fitted or forecasted value of the
variable.

ßYou can think of MSE as the average forecast error.

ßIf we have a perfect forecast, then MSE = 0.
 Actual

Predicted
Time
Root Mean Square Error (root MSE) is given by:

1 m
rootMSE  
m t 1
(Yt  ˆ
Y t ) 2

Root MSE is a statistic

that is typically is reported
by forecasting software
applications
 The time path of a variable (such as monthly sales of
building materials by supply stores) is produced by the
interaction of 4 factors or components. These
components are:
1. The trend component (T)
2. The seasonal component (S)
3. The cyclical component (C); and
4. The irregular component (I)
The trend component (T)
Trend is the gradual, long-
run (or secular) evolution
of the variables that we are
seeking to forecast.
Factors affecting the trend component of a
time series
•Population changes
•Demographic changes. For example, spending for
healthcare services is likely to rise due to the aging
of the population. Sales of fast food are up due to
the secular increase in the female labor force
participation rate.
•Technological change. Sales of music on DVD have
slumped due to Ipods. Typewriter sales have
plumetted.
•Changes in consumer tastes and preferences.
 Linear trends
40

20 Trend = 10 – 25t

-20

-40

Trend = -50 + .8t

-60
10 20 30 40 50 60 70 80 90 100
 Non-linear, increasing trend
4000

3000

Trend = 10 + .3t + .3t2

2000

1000

0
10 20 30 40 50 60 70 80 90 100
 Non-linear, decreasing trend

1000

0 Trend = 10 - .4t - .4t2

-1000

-2000

-3000

-4000

-5000
10 20 30 40 50 60 70 80 90 100
The seasonal component (S)

•Many series display a regular pattern of

variability depending on the time of year.
•For example, sales of toys and scotch
whiskey peak in December each year.
•Ice cream sales are higher in summer
months than in winter months.
•Car sales tend typically to be strong
in May and June and weaker in
November and December.
The cyclical component (C)

•The time path of a series can be influenced by business

cycle fluctuations.
•For example, we expect housing starts to decline in the
contractionary phase of the business cycle.
•The same holds true for federal or state tax receipts
•The time path of spending for consumer durable goods
is also shaped by cyclical forces.
•Spending for capital goods is likewise cyclical.
•The movie industry has the reputation for being
“counter-cyclical”—for example, it flourished during
the Depression.
The irregular component (I)
•The irregular component of the series, sometimes
called white noise, is the remaining variability (relative
to trend) that cannot be explained by seasonal or
cyclical factors. The irregular component is an
unexpected, non-recurring factor that affects the series.
•For example, hamburger sales plunge due to panic
about E-Coli bacteria.
•Production of trucks slumps because of a strike at a
GM parts plant in Ohio.
•Airline slump after 9/11.
•A cold snap affects July ice cream sales in upstate NY.
 If you have a well-designed
forecasting model, then forecasting
errors should be mainly accounted
for by irregular factors
The model
Yt  Tt  St  Ct  It
Where:
•Yt is the value of the time series variable in period t
(month t, quarter t, etc.)
•Tt trend component of the series in period t
•St is the seasonal component of the series in period t
•Ct is the cylical component of the series at period t;
and
•It is the irregular component of the series in period t.
The trend component (T) is measured in the
units in which the time series itself is
measured. So, for example, the trend
component for state revenues would be
measured in dollars; whereas the trend
component for steel production might be
measured in tons.
 The Problem: Forecast Sales of Home
Furnishing Stores, October-December, 2007
The data:
•We have monthly data of sales of home
furniture stores January 1992 to July 2007
(187 monthly observations).
•The data are expressed in millions of
current dollars, not seasonally adjusted
 t Yr Mo $
1 1992 1 1460
2 1992 2 1453
3 1992 3 1556
4 1992 4 1622
5 1992 5 1675
6 1992 6 1759
7 1992 7 1789
8 1992 8 1814
9 1992 9 1721
10 1992 10 1839
11 1992 11 1925
12 1992 12 2246
" " " "
" " " "
187 2007 7 4803

The Data
 Sales of Home Furnishing Stores, 1992-2007
(millions of dollars, NSA)
7000

6000

5000

4000

3000

2000

1000
92 94 96 98 00 02 04 06
Year/Month
Source: Economagic.com
 Our first step is to estimate the
trend component of our series.
This is accomplished using a
ordinary least squares, or OLS for short.

•OLS is a method of finding the line, or curve, of

“best fit.”
•The trend function of best fit is the one that
minimizes the squared sum of the vertical distances
of the sample points (the actual monthly values of
home furnishing sales) from the trend line (fitted
values of monthly building materials sales).
Let:
•Yt be the actual value of furniture store sales in
month t;
•Let Ŷt be the trend value of furniture store sales
in month t. The trend function we are seeking
satisfies the following condition:

187
MIN . (Y t  Yˆt ) 2
t 1
We estimate a linear
trend function with Excel.
It is displayed on the next
slide.
 Linear Trend Line Fitted to
Home Furnishing Data
7000

6000 y = 17.62x + 1475.

R2 = 0.83
5000

4000

3000

2000

1000

0
0 20 40 60 80 100 120 140 160 180 200

t
 Actual and Trend Values of Hom Furniture Sales (in millions)
7000

6000

5000

4000

3000

2000

1000
92 94 96 98 00 02 04 06
Year/Month
Actual TREND
 Seasonal Index
Month Index
Jan 0.8799 •If you sum the
Feb 0.8475 monthly values and
Mar 0.9823 divide by 12, you
Apr 0.9004 get 1.00.
May 0.9939
•Later we show a
Jun 1.0197
simple technique
Jul 0.9729
Aug 1.0487 for computing a
Sep 1.0042 seasonal index.
Oct 0.9962
Nov 1.123
Dec 1.2969
Performing an in-sample forecast of home
furnishing sales
•An in-sample forecast means we are forecasting
home furshing sales for those months for which we
already have data that have been used to estimate the
trend, seasonal, and other components. Comparing
forecasted, or fitted values of home furnishing sales
with actual time series data gives us an idea of how
well this performs.
•We will assume that the cyclical index is equal to 1
(Ct = 1). This is a poor assumption since our period
contains two business cycle contractions.
 Let’s give an example how we
use this model to Home
furnishing sales for a
particular month, say, April
1998 . t = 76 for this month

FˆApr98  Tt  St  Ct

FˆApr98  [(17.62  76)  1475]  0.900 1  $2,532.71

In-Sample Forecast of Home Furnishing Sales Using Multiplicative Model
7000

6000

5000

4000

3000

2000

1000
94 96 98 00 02 04 06
Year/Month
Multiplcative model Home furnishing sales (millions)
Residuals from In-sample Forecast of Home Furnishing Sales (in millions)
300
Recession is shaded

200

100

-100

-200

-300
94 96 98 00 02 04 06
Year/Month
MSE  $103.275
Forecasting Using the Multiplicative
Model

t Yr/Mo Trend Seasonal Cyclical Forecast

190 2007/Oct 4822.8 0.9962 0.999 4799.669
191 2007/Nov 4840.42 1.123 0.979 5321.64
192 2007/Dec 4858.04 1.2969 0.975 6142.882