David, there was a thread on Optical Encoders, dated 8/26/01. I learned a bit about the subject asking the same questions you're contending with now.

One of the fifteen responses (maybe it was Erik) had the waveforms associated with missing pulses.

I concluded from the thread that a micro could process a quadrature encoder to sufficient accuracy if the encoder was being used to alter a disply value or position a cursor like a mouse. However, if the encoder is used as a position feedback device in a closed loop control system, dedicated hardware (like a programmable logic device or hardwired gates) is the only sure way to avoid position indication errors.

Good Luck,

Bruce