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Updated at the bottom: We have short memories in Silicon Valley, which is both a blessing and a curse. We forget the bad times as quickly as we forget the good times.

At the turn of the century, everything went to hell with the dot-com bust. Then the pendulum started to swing the other way; the pessimism that once reigned supreme was being replaced by wild-eyed optimism. Now Silicon Valley is in for a long-overdue reality check, one that should worry one and all. Why? Because the news coming out of advertising-focused companies is not good.

Yesterday ValueClick, a display advertising network, said it now expects its second-quarter revenues to range from $162 million to $164 million, lower than the previously forecasted $170 million. The company also cut its full-year 2008 sales guidance by about 10 percent, to between $655 million and $675 million. It blamed weakness in its display and comparison advertising business, and flatness even in its lead-generation business.

Time Warner’s Platform-A advertising division isn’t doing so well either, according to some of my sources. The company is instituting wide-scale belt-tightening measures, including freezing travel budgets. Pali Capital in a blog post today forecast, “AOL’s display advertising revenues down about 8% in Q2 (Q1 ‘08 was down about 10% organically), with the back-half down mid-single digits.”

Microsoft, in its fourth-quarter 2008 earnings call today, also admitted that online advertising was tough. “The one proviso to that is in the online advertising space…it was weak in the fourth quarter. There is a direct impact and we’re not immune in the online space, ” Microsoft CFO Chris Liddel said in a conference call with analysts. “The online advertising area is part of the business that we think is most challenging…the online advertising area is very difficult at the moment.”

And if that wasn’t enough, Google just announced spectacular growth in its second-quarter revenues — about 39 percent over the same period lat year — but fell short of Wall Street’s profit expectations. Between The Lines blog notes that Google CEO Eric Schmidt, in his company’s conference call with investors, said they would survive the downturn because there will be a flight to quality, and that they will provide a better return on investment. Maybe! Larry Dignan hit the nail on the head when he wrote:

“Color me skeptical. Anyone that lived through the dot-com bust has heard these lines before and no company is immune if there’s a recession.”

Like him, the skeptical me went straight to the traffic acquisition costs (TAC), which is where I think the real story lies. If you look at the image below you’ll see that Google’s traffic acquisition costs have declined rapidly while its revenues have ballooned. TAC in general and AdSense specifically are like a black box – no one quite knows how much Google gives out. Sometimes it feels like Google can use this “black box” to come up with pretty much any numbers it wants to.

We’ll get a better sense of the overall health of the market when Yahoo reports its latest numbers, but the way I see it, things are sort of troubling. We wrote about this nagging problem back in May. I think that as we go forward things are only going to get worse — and even Silicon Valley can’t ignore what’s been going on in the overall economy.

The housing crisis is being replaced by a much scarier problem: the personal credit crunch. In a recent report, American Express noted that it has started to see a sharp increase in late card payments. Now folks, this is American Express, whose customers skew towards the affluent, especially compared to those of its competitors. The company has boosted loss provisions for its U.S. card business, profits have declined, and defaults are up.

Will these problems escalate? Probably. Consumers struggling with the housing crisis and rising fuel costs — and thus higher basic living expenses — will be forced to cut back on other spending, which will lead to slower sales and in turn, less money for advertising.

We know the housing and financial sector-related ads have already declined drastically, now we’re going to start to see other sectors cut back on advertising, too — and that is going to have a negative impact on everyone from large social networks to ad networks to Yahoo and Google to small startups, including weblogs like ours. I guess Provigil sales are going to take a nosedive in the Valley as we stay up all night worrying about everything.

Update: And there’s more bad news today. The Wall Street Journal reports that General Motors is going to sharply cut back on advertising. GM is one of the big spenders in U.S. — last year the company spent about 32 percent of its $2.3 billion dollar ad budget on newspapers and 11 percent on television networks — but it looks like those expenditures are going to get hacked. It’s not clear from the report how this move will impact Internet advertising.

Photo courtesy of ZDNet

The battle over Yahoo’s search business as witnessed over the last few days seems both ridiculous and petty. And it takes the attention away from what is Yahoo’s true value: a media aggregation platform. Yahoo is the place a lot of people — some 400 million — visit to get their news, sports scores and email. I have always liked that business, and yesterday I experienced, first-hand, the enormous strength of Yahoo.

A story by Judi Sohn, who edits WebWorkerDaily, one of our growing portfolio of blogs, was featured on the home page of Yahoo last night. The story got voted up via Yahoo’s Buzz, a service akin to Digg, except much more powerful.

In a few hours, the story about what to expect when switching from a BlackBerry to an iPhone was viewed over 200,000 times and attracted over 350 comments. Now that’s a lot of traffic — but more importantly, a gigantic amount of engagement displayed by Yahoo visitors. The traffic sent our way by Yahoo was many times the traffic we get from, say, Digg or StumbleUpon.

At the risk of repeating myself, Yahoo’s core business now is “audience.” The company, instead of trying to out-Google Google, needs to beat itself by figuring out new ways to keep the audience growing. The first step is, of course, acknowledging that it is a content company. The next one: figuring out new engagement and audience-grabbing ways.

Second Life is either peaking or busy crossing the chasm, depending on who you believe. IMVU stealthed its way to tons of users. Club Penguin found its windfall by figuring out how to reach children safely. Blizzard had revenues of $1.1 billion last year. Qwaq makes private virtual worlds for the enterprise. And there are dozens more. Do we really need another?

Then along comes Lively. At first blush, as James points out, it’s a me-too play. But Google’s other projects may mean it can do things other virtual worlds can’t.

First, of course, there’s advertising. Google can sell wall space. All those walls are good real estate for interstitial video ads. And social ads are better: Recommendations in your friends’ rooms cut through the advertising clutter, which makes Lively a good vehicle for social advertising without inviting the Beacon Creepy Stalker Guy along for the ride.

Second, Google has payment. Not only for buying in-game things, but for purchasing the physical equivalent (through Googlebase, paid with Checkout.)

But Google Earth (acquired from Keyhole) and SketchUp (an incredibly easy-to-use modeling tool bought in 2006 and subsequently released for free) are far more interesting. Google already has millions of structures, both those it built itself and those its community built. They’re mapped to a planet with coordinates and roads. Put the two together and Google’s in the real estate business:

“Mr. Trump, the folks from Google are here.”

“Fine, send them in.”

“Hi, Donald. Would you like to buy Trump Tower?”

“What? I own Trump tower!”

“We meant the Lively/Google Earth version.”

“Get the hell out of my office! You’re fired!”

“OK, then, crack dens and whorehouses it is…”

“Wait a second…”

If you’re in advertising, it’s all about location. Anyone want virtual Madison Avenue?

This morning’s Wall Street Journal has an extensive report on challenges facing Google when it comes to advertising, especially with its YouTube division. If anything, the article paints a rather sympathetic view of Google and its money machine. I am surprised by the timing of this story. After all, these problems are quite well known and have been subject of many tomes.

I wonder if this story and Google’s challenges are meant to portray the search-and-online advertising giant as an underdog and win it some sympathy from regulators as it goes in to get its advertising deal with Yahoo approved. As a great counterpoint to the WSJ report, I urge you to read this spectacular and refreshingly honest editorial by Richard Bennett in today’s San Francisco Chronicle. Bennett correctly points out that Google is using the Net Neutrality debate to divert attention from the real issue of how it is going to become the tyrant of online advertising.

Despite its carefully crafted public image as a naive and squeaky-clean innovator, Google is a public corporation managed by professionals, some of them longtime friends of Washington power brokers and fully capable of understanding the problems the Google-Yahoo deal poses.

The tech press has been too busy reprising its Internet Bubble era cheerleading and cooing about Google’s network neutrality “idealism” to raise questions about the demise of Yahoo as a search competitor.

Bennett’s piece meshes with my thinking about Google and its Network Neutrality/broadband doublespeak.

The deal, as currently structured, substantially alters the Internet economy. Advertising is the prime revenue stream for social networks, news sites and Internet aggregators of all kinds, and it’s closely linked to search. Instead of a search market where three players compete vigorously for eyeballs, this deal would create a status quo where the top dog enjoys an 85 percent market share and the ability to set prices for search ads with no fear of being undercut by its much weaker sole competitor. This should set alarms clanging wherever antitrust and personal privacy concerns are held dear, but it hasn’t.