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I lean toward other factors on the linking page, possibly in concert with the abundance of similar anchors, working together to cause the effect.
Would you include poor quality sites e.g. typically blogs that no-one reads, or off topic blogs linking, per MC's interview with Eric Enge
John Mueller @ Google said: In general, if you remove the page that is being linked to (such as a spammy forum thread) and make sure that it returns a 404/410 HTTP response code, we'll ignore the links to those pages. If these links are primarily pointing at threads that you've removed, then there's no need to move the whole forum to a new URL. If you find that there's a significant number of problematic links that you can't remove which are linking to general parts of your forum (eg the forum homepage), moving the forum to a different URL might be a possibility (but I'd only recommend doing that if you're absolutely sure that these links are causing problems -- we're pretty good at ignoring spammy links). If you choose to move the forum, then StevieD has some good suggestions on how that could be done (make sure that your 404 page is useful to users too). [productforums.google.com...]
It's interesting that he went on to say that those links generally only harm the specific pages they point to and not the whole site.
But I wonder if this is the best solution when you've got great links mixed in with the bad ones, which cannot be easily moved to new pages.
Is it possible that the tanking is the result of the links no longer working and that the new positions are pretty much where they should rank if those links did not exist?
[edited by: martinibuster at 6:12 am (utc) on Jul 24, 2012]
[edit reason] Removed guess-able specifics. [/edit]
With point D are you saying that image links are a good way to deal with text links that might appear to be paid?
pt B: If G is using this as a criteria, they are being highly presumptive and unfair.
Top Ten Strategies For Dealing With Poisoned Inbound Links
A dramatic loss of ranking and traffic.
Or is the Penguin Update supposed to work sitewide and my issue may be simply inbound links losing power?
[edited by: martinibuster at 12:58 pm (utc) on Jul 24, 2012]
Absolutely, do not panic. Never panic. If you are certain that the links you built are crap, then you're probably starting to rank where you are supposed to rank should your crap links not be useful anymore.
Is there any single piece of evidence that cleaning up helps?
A lot of site owners are going to drive themselves crazy removing, or trying to remove 'bad' links. But after all that, their sites rankings won't improve.
They seem to be so concerned about link building activities :p
My simple suggestion to google if at all they are manually checking sites then instead of concentrating majorly on links they should focus on usability, infographs and responsiveness of the website as a stronger parameter over others to rank. This way right set of sites would be served to google users