UNIT 14 TREND ANALYSIS-II

Structure
14.0 Learning Objectives
14.1 Introduction
14.2 Forecasting Methods
14.3 Modelling Seasonality and Trend
14.4 Trend Analysis
14.5 Modelling Seasonality and Trend
14.6 Decomposition Analysis
14.7 Seasonal Variation
14.8 Cyclical Variation
14.9 Summary
14.10 Keywords
14.11 Learning Activity
14.12 Unit End Questions
14.13 References

14.0 LEARNING OBJECTIVES

After studying this unit, students will be able to:

 Explain the Forecasting Methods and Trend Analysis

 Discuss the Modeling Seasonality and Trend
 State the Seasonal Variation and Cyclical Variation
 Describe the Decomposition Analysis

14.1 INTRODUCTION

Ideally, organizations which can afford to do so will usually assign crucial forecast
responsibilities to those departments and/or individuals that are best qualified and have the
necessary resources at hand to make such forecast estimations under complicated demand
patterns. Clearly, a firm with a large ongoing operation and a technical staff comprised of
statisticians, management scientists, computer analysts, etc. is in a much better position to
select and make proper use of sophisticated forecast techniques than is a company with more
limited resources. Notably, the bigger firm, through its larger resources, has a competitive

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edge over an unwary smaller firm and can be expected to be very diligent and detailed in
estimating forecast (although between the two, it is usually the smaller firm which can least
afford miscalculations in new forecast levels).

14.2 FORECASTING METHODS

A time series is a set of ordered observations on a quantitative characteristic of a

phenomenon at equally spaced time points. One of the main goals of time series analysis is to
forecast future values of the series.
A trend is a regular, slowly evolving change in the series level. Changes that can be modelled
by low-order polynomials
We examine three general classes of models that can be constructed for purposes of
forecasting or policy analysis. Each involves a different degree of model complexity and
presumes a different level of comprehension about the processes one is trying to model.
Many of us often either use or produce forecasts of one sort or another. Few of us recognize,
however, that some kind of logical structure, or model, is implicit in every forecast.
In making a forecast, it is also important to provide a measure of how accurate one can expect
the forecast to be. The use of intuitive methods usually precludes any quantitative measure of
confidence in the resulting forecast. The statistical analysis of the individual relationships that
make up a model, and of the model as a whole, makes it possible to attach a measure of
confidence to the modelÂ’s forecasts.
Once a model has been constructed and fitted to data, a sensitivity analysis can be used to
study many of its properties. In particular, the effects of small changes in individual variables
in the model can be evaluated. For example, in the case of a model that describes and predicts
interest rates, one could measure the effect on a particular interest rate of a change in the rate
of inflation. This type of sensitivity study can be performed only if the model is an explicit
one.
In Time-Series Models we presume to know nothing about the causality that affects the
variable we are trying to forecast. Instead, we examine the past behaviour of a time series in
order to infer something about its future behaviour. The method used to produce a forecast
may involve the use of a simple deterministic model such as a linear extrapolation or the use
of a complex stochastic model for adaptive forecasting.
One example of the use of time-series analysis would be the simple extrapolation of a past
trend in predicting population growth. Another example would be the development of a
complex linear stochastic model for passenger loads on an airline. Time-series models have
been used to forecast the demand for airline capacity, seasonal telephone demand, the
movement of short-term interest rates, and other economic variables. Time-series models are
particularly useful when little is known about the underlying process one is trying to forecast.

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The limited structure in time-series models makes them reliable only in the short run, but they
are nonetheless rather useful.
In the Single-Equation Regression Models the variable under study is explained by a single
function (linear or nonlinear) of a number of explanatory variables. The equation will often
be time-dependent (i.e., the time index will appear explicitly in the model), so that one can
predict the response over time of the variable under study to changes in one or more of the
explanatory variables. A principal purpose for constructing single-equation regression models
is forecasting. A forecast is a quantitative estimate (or set of estimates) about the likelihood
of future events which is developed on the basis of past and current information. This
information is embodied in the form of a model—a single-equation structural model and a
multi-equation model or a time-series model. By extrapolating our models beyond the period
over which they were estimated, we can make forecasts about near future events. This section
shows how the single-equation regression model can be used as a forecasting tool.
The term forecasting is often thought to apply solely to problems in which we predict the
future. We shall remain consistent with this notion by orienting our notation and discussion
toward time-series forecasting. We stress, however, that most of the analysis applies equally
well to cross-section models.
An example of a single-equation regression model would be an equation that relates a
particular interest rate, such as the money supply, the rate of inflation, and the rate of change
in the gross national product.
The choice of the type of model to develop involves trade-offs between time, energy, costs,
and desired forecast precision. The construction of a multi-equation simulation model may
require large expenditures of time and money. The gains from this effort may include a better
understanding of the relationships and structure involved as well as the ability to make a
better forecast. However, in some cases these gains may be small enough to be outweighed
by the heavy costs involved. Because the multi-equation model necessitates a good deal of
knowledge about the process being studied, the construction of such models may be
extremely difficult.
The decision to build a time-series model usually occurs when little or nothing is known
about the determinants of the variable being studied, when a large number of data points are
available, and when the model is to be used largely for short-term forecasting. Given some
information about the processes involved, however, it may be reasonable for a forecaster to
construct both types of models and compare their relative performance.
Two types of forecasts can be useful. Point forecasts predict a single number in each forecast
period, while interval forecasts indicate an interval in which we hope the realized value will
lie. We begin by discussing point forecasts, after which we consider how confidence intervals
(interval forecasts) can be used to provide a margin of error around point forecasts.

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The information provided by the forecasting process can be used in many ways. An important
concern in forecasting is the problem of evaluating the nature of the forecast error by using
the appropriate statistical tests. We define the best forecast as the one which yields the
forecast error with the minimum variance. In the single-equation regression model, ordinary
lest-squares estimation yields the best forecast among all linear unbiased estimators having
minimum mean-square error.
The error associated with a forecasting procedure can come from a combination of four
distinct sources. First, the random nature of the additive error process in a linear regression
model guarantees that forecasts will deviate from true values even if the model is specified
correctly and its parameter values are known. Second, the process of estimating the
regression parameters introduces error because estimated parameter values are random
variables that may deviate from the true parameter values. Third, in the case of a conditional
forecast, errors are introduced when forecasts are made for the values of the explanatory
variables for the period in which the forecast is made. Fourth, errors may be introduced
because the model specification may not be an accurate representation of the "true" model.
Multi-predictor regression methods include logistic models for binary outcomes, the Cox
model for right-censored survival times, repeated-measures models for longitudinal and
hierarchical outcomes, and generalized linear models for counts and other outcomes. Below
we outline some effective forecasting approaches, especially for short to intermediate term
analysis and forecasting:

14.3 MODELING THE CAUSAL TIME SERIES:

With multiple regressions, we can use more than one predictor. It is always best, however, to
be parsimonious, that is to use as few variables as predictors as necessary to get a reasonably
accurate forecast. Multiple regressions are best modelled with commercial package such as
SAS or SPSS. The forecast takes the form:
Y = b0 + b1X1 + b2X2 + . . .+ bnXn,
where b0 is the intercept, b1, b2, . . . bn are coefficients representing the contribution of the
independent variables X1, X2..., Xn.
Forecasting is a prediction of what will occur in the future, and it is an uncertain process.
Because of the uncertainty, the accuracy of a forecast is as important as the outcome
predicted by forecasting the independent variables X1, X2..., Xn. A forecast control must be
used to determine if the accuracy of the forecast is within acceptable limits. Two widely used
methods of forecast control are a tracking signal, and statistical control limits.
Tracking signal is computed by dividing the total residuals by their mean absolute deviation
(MAD). To stay within 3 standard deviations, the tracking signal that is within 3.75 MAD is
often considered to be good enough.

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Statistical control limits are calculated in a manner similar to other quality control limit
charts, however, the residual standard deviation are used.
Multiple regressions are used when two or more independent factors are involved, and it is
widely used for short to intermediate term forecasting. They are used to assess which factors
to include and which to exclude. They can be used to develop alternate models with different
factors.

14.4 TREND ANALYSIS:

Uses linear and nonlinear regression with time as the explanatory variable, it is used where
pattern over time have a long-term trend. Unlike most time-series forecasting techniques, the
Trend Analysis does not assume the condition of equally spaced time series.
Nonlinear regression does not assume a linear relationship between variables. It is frequently
used when time is the independent variable.

14.5 MODELLING SEASONALITY AND TREND:

Seasonality is a pattern that repeats for each period. For example annual seasonal pattern has
a cycle that is 12 periods long, if the periods are months, or 4 periods long if the periods are
quarters. We need to get an estimate of the seasonal index for each month, or other periods,
such as quarter, week, etc, depending on the data availability.
1. Seasonal Index: Seasonal index represents the extent of seasonal influence for a particular
segment of the year. The calculation involves a comparison of the expected values of that
period to the grand mean.
A seasonal index is how much the average for that particular period tends to be above (or
below) the grand average. Therefore, to get an accurate estimate for the seasonal index, we
compute the average of the first period of the cycle, and the second period, etc, and divide
each by the overall average. The formula for computing seasonal factors is:
Si = Di /D,
where: Si = the seasonal index for ith period,
Di = the average values of i th period,
D = grand average,
i = the ith seasonal period of the cycle.
A seasonal index of 1.00 for a particular month indicates that the expected value of that
month is 1/12 of the overall average. A seasonal index of 1.25 indicates that the expected
value for that month is 25% greater than 1/12 of the overall average. A seasonal index of 80
indicates that the expected value for that month is 20% less than 1/12 of the overall average.

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2. De-seasonalizing Process: De-seasonalizing the data, also called Seasonal Adjustment is
the process of removing recurrent and periodic variations over a short time frame, e.g.,
weeks, quarters, months. Therefore, seasonal variations are regularly repeating movements in
series values that can be tied to recurring events. The De-seasonalized data is obtained by
simply dividing each time series observation by the corresponding seasonal index.
Almost all time series published by the US government are already de-seasonalized using the
seasonal index to unmasking the underlying trends in the data, which could have been caused
by the seasonality factor.
3. Forecasting: Incorporating seasonality in a forecast is useful when the time series has
both trend and seasonal components. The final step in the forecast is to use the seasonal index
to adjust the trend projection. One simple way to forecast using a seasonal adjustment is to
use a seasonal factor in combination with an appropriate underlying trend of total value of
cycles.
4. A Numerical Application: The following table provides monthly sales ($1000) at a
college bookstore. The sales show a seasonal pattern, with the greatest number when the
college is in session and decrease during the summer months.

Suppose we wish to calculate seasonal factors and a trend, then calculate the forecasted sales
for July in year 5.
The first step in the seasonal forecast will be to compute monthly indices using the past four-
year sales. For example, for January the index is:
S(Jan) = D(Jan)/D = 208.6/181.84 = 1.14,
where D(Jan) is the mean of all four January months, and D is the grand mean of all past
four-year sales.
Similar calculations are made for all other months. Indices are summarized in the last row of
the above table. Notice that the mean (average value) for the monthly indices adds up to 12,
which is the number of periods in a year for the monthly data.
Next, a linear trend often is calculated using the annual sales:
Y = 1684 + 200.4T,

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The main question is whether this equation represents the trend.

Often fitting a straight line to the seasonal data is misleading. By constructing the scatter
diagram, we notice that a Parabola might be a better fit. Using the Polynomial Regression
JavaScript, the estimated quadratic trend is:
Y = 2169 - 284.6T + 97T2
Predicted values using both the linear and the quadratic trends are presented in the above
tables. Comparing the predicted values of the two models with the actual data indicates that
the quadratic trend is a much superior fit than the linear one, as often expected.
We can now forecast the next annual sales; which, corresponds to year 5, or T = 5 in the
above quadratic equation:
Y = 2169 - 284.6(5) + 97(5)2 = 3171
sales for the following year. The average monthly sales during next year are, therefore:
3171/12 = 264.25.
Finally, the forecast for month of July is calculated by multiplying the average monthly sales
forecast by the July seasonal index, which is 0.79; i.e., (264.25). (0.79) or 209.
You might like to use the Seasonal Index JavaScript to check your hand computation. As
always you must first use Plot of the Time Series as a tool for the initial characterization
process.
For testing seasonality based on seasonal index, you may like to use the Test for Seasonality
JavaScript.
Trend Removal and Cyclical Analysis: The cycles can be easily studied if the trend itself is
removed. This is done by expressing each actual value in the time series as a percentage of
the calculated trend for the same date. The resulting time series has no trend, but oscillates
around a central value of 100.

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14.6 DECOMPOSITION ANALYSIS:

It is the pattern generated by the time series and not necessarily the individual data values that
offers to the manager who is an observer, a planner, or a controller of the system. Therefore,
the Decomposition Analysis is used to identify several patterns that appear simultaneously in
a time series.
A variety of factors are likely influencing data. It is very important in the study that these
different influences or components be separated or decomposed out of the 'raw' data levels. In
general, there are four types of components in time series analysis: Seasonality, Trend,
Cycling and Irregularity.
Xt = St . Tt . Ct . I
The first three components are deterministic which are called "Signals", while the last
component is a random variable, which is called "Noise". To be able to make a proper
forecast, we must know to what extent each component is present in the data. Hence, to
understand and measure these components, the forecast procedure involves initially removing
the component effects from the data (decomposition). After the effects are measured, making
a forecast involves putting back the components on forecast estimates (recomposition). The
time series decomposition process is depicted by the following flowchart:

Definitions of the major components in the above flowchart:

14.7 SEASONAL VARIATION:

When a repetitive pattern is observed over some time horizon, the series is said to have
seasonal behaviour. Seasonal effects are usually associated with calendar or climatic changes.
Seasonal variation is frequently tied to yearly cycles.
Trend: A time series may be stationary or exhibit trend over time. Long-term trend is
typically modelled as a linear, quadratic or exponential function.

14.8 CYCLICAL VARIATION:

An upturn or downturn not tied to seasonal variation. Usually results from changes in
economic conditions.
1. Seasonality’s are regular fluctuations which are repeated from year to year with about the
same timing and level of intensity. The first step of a times series decomposition is to remove

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seasonal effects in the data. Without de-seasonalizing the data, we may, for example,
incorrectly infer that recent increase patterns will continue indefinitely; i.e., a growth trend is
present, when actually the increase is 'just because it is that time of the year'; i.e., due to
regular seasonal peaks. To measure seasonal effects, we calculate a series of seasonal
indexes. A practical and widely used method to compute these indexes is the ratio-to-moving-
average approach. From such indexes, we may quantitatively measure how far above or
below a given period stands in comparison to the expected or 'business as usual' data period
(the expected data are represented by a seasonal index of 100%, or 1.0).
2. Trend is growth or decay that is the tendencies for data to increase or decrease fairly
steadily over time. Using the de-seasonalized data, we now wish to consider the growth trend
as noted in our initial inspection of the time series. Measurement of the trend component is
done by fitting a line or any other function. This fitted function is calculated by the method of
least squares and represents the overall trend of the data over time.
3. Cyclic oscillations are general up-and-down data changes; due to changes e.g., in the
overall economic environment (not caused by seasonal effects) such as recession-and
expansion. To measure how the general cycle affects data levels, we calculate a series of
cyclic indexes. Theoretically, the de-seasonalized data still contains trend, cyclic, and
irregular components. Also, we believe predicted data levels using the trend equation do
represent pure trend effects. Thus, it stands to reason that the ratio of these respective data
values should provide an index which reflects cyclic and irregular components only. As the
business cycle is usually longer than the seasonal cycle, it should be understood that cyclic
analysis is not expected to be as accurate as a seasonal analysis.
Due to the tremendous complexity of general economic factors on long term behaviour, a
general approximation of the cyclic factor is the more realistic aim. Thus, the specific sharp
upturns and downturns are not so much the primary interest as the general tendency of the
cyclic effect to gradually move in either direction. To study the general cyclic movement
rather than precise cyclic changes (which may falsely indicate more accurately than is present
under this situation), we 'smooth' out the cyclic plot by replacing each index calculation often
with a centered 3-period moving average. The reader should note that as the number of
periods in the moving average increases, the smoother or flatter the data become. The choice
of 3 periods perhaps viewed as slightly subjective may be justified as an attempt to smooth
out the many up-and-down minor actions of the cycle index plot so that only the major
changes remain.
4. Irregularities (I) are any fluctuations not classified as one of the above. This component of
the time series is unexplainable; therefore it is unpredictable. Estimation of I can be expected
only when its variance is not too large. Otherwise, it is not possible to decompose the series.
If the magnitude of variation is large, the projection for the future values will be inaccurate.
The best one can do is to give a probabilistic interval for the future value given the
probability of I is known.

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5. Making a Forecast: At this point of the analysis, after we have completed the study of the
time series components, we now project the future values in making forecasts for the next
few periods. The procedure is summarized below.
Step 1: Compute the future trend level using the trend equation.
Step 2: Multiply the trend level from Step 1 by the period seasonal index to include seasonal
effects. Step 3: Multiply the result of Step 2 by the projected cyclic index to include cyclic
effects and get the final forecast result.

14.9 SUMMARY

 Three general classes of models that can be constructed for purposes of forecasting or
policy analysis. Each involves a different degree of model complexity and presumes a
different level of comprehension about the processes one is trying to model. Time-
series models have been used to forecast the demand for airline capacity, seasonal
telephone demand, the movement of short-term interest rates, and other economic
variables. In making a forecast, it is also important to provide a measure of how
accurate one can expect the forecast to be. The use of intuitive methods usually
precludes any quantitative measure of confidence in the resulting forecast.
 In the Single-Equation Regression Models the variable under study is explained by a
single function (linear or nonlinear) of a number of explanatory variables. The choice
of the type of model to develop involves trade-offs between time, energy, costs, and
desired forecast precision. The construction of a multi-equation simulation model may
require large expenditures of time and money. The decision to build a time-series
model usually occurs when little or nothing is known about the determinants of the
variable being studied. It may be reasonable for a forecaster to construct both types of
models and compare their relative performance.

 Two types of forecasts can be useful. Point forecasts predict a single number in each
forecast period, while interval forecasts indicate an interval in which we hope the
realized value will lie. Error associated with a forecasting procedure can come from a
combination of four distinct sources. Multi-predictor regression methods include
logistic models for binary outcomes and the Cox model for right-censored survival
times.

14.10 KEYWORDS

 Seasonal variation:Seasonal variation is variation in a time series within one year

that is repeated more or less regularly. Seasonal variation may be caused by the
temperature, rainfall, public holidays, cycles of seasons or holidays

 Trend: A “trend” is an upwards or downwards shift in a data set over time. In

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 economics, “trend analysis” usually refers to analysis on past trends in market trading;

 Link relative: the ratio usually expressed in percent of any value of a statistical
variable evaluated at equal intervals of time (as annual crop yield) to the value for the
immediately preceding interval.

14.11 LEARNING ACTIVITY

1. Assuming no trend in the series, Calculate seasonal indices for the following data

___________________________________________________________________________
____________________________________________________________________

14.12 UNIT END QUESTIONS

A. Descriptive Questions:
Short Questions
1. What is trend?
2. What is seasonal variation?
3. What is cyclical variation?
4. Write the formula for Link Relative Method?
Long Questions
1. Discuss link relative method?
2. Explain de-seasonalisation?
3. Explain Forecasting.
4. Discuss the different models of time series.

B. Multiple choice questions

1. An orderly set of data arranged in accordance with their time of occurrence is called:
a. Arithmetic series

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 b. Harmonic series
c. Geometric series
d. Time series

2. A time series consists of:

a. Short-term variations
b. Long-term variations
c. Irregular variations
d. All of these

3. The graph of time series is called:

a. Histogram
b. Straight line
c. Histogram
d. Ogive

4. Secular trend can be measured by:

a. Two methods
b. Three methods
c. Four methods
d. Five methods

5. The secular trend is measured by the method of semi-averages when:

a. Time series based on yearly values
b. Trend is linear
c. Time series consists of even number of values
d. None of these

Answer
1) d 2) d 3) c 4) c 5) b

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14.13 REFERENCES

Textbooks / Reference Books

 T1: Levine, D., Sazbat, K. and Stephan, D. 2013. Business Statistics, 7thEdition,
Pearson Education, India, ISBN: 9780132807265.
 T2; Gupta, C. and Gupta, V. 2004. An Introduction to Statistical Methods,
23rdEdition, Vikas Publications, India, ISBN: 9788125916543.

 R1: Croucher, J. 2011. Statistics: Making Business Decisions, 13thEdition, Tata

McGraw Hill, ISBN: 9780074710419.

 R2 Gupta, S. 2011. Statistical Methods, 4thEdition, Sultan Chand & Sons, ISBN:
8180548627.

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