Probably already been done...

Get a laser pionter (the cheaper the better)
Get a mirror (or light sensor)
Place laser at X distance from sensor (sensor from CD player may be of use!)
Switch the laser on and off, - read the the time it takes to sense the beam... whalla you have an encoder with light speed resolution!!

--anyone tried this?

or....

Get a cdrom - burn this sequnce into iit 0101010101010101 etc

rip apart a cdrom drive and hook it up to your rotary drive, with the cd you just burnt as being your 'indexing wheel' .... hook up the cdrom, and somehow bypass the motor drive flag on it, while still being able to access it reading. Now use the rotation of the cdrom disc as the resolution of indexing for everytime the cd drive senses a 1. - maybe a floppy drive could be used the same way?
--you could change the indexing resolution by burning differening cdroms, or you could even make 'programmed indexs' for rotary milling.