Justin, congratulations on your "new" 560SEL. How is it to drive the 1987 "Flagship" of the line?
I'll second Larry's thought; it may be a loose or corroded connector which adds resistance and thus looks like lower temperature. When you find the connector(s) have a good look at them. Shiny, or dull copper is good, green gunk is not good.
Nicked, cracked or pinched wires could make an intermittent connection.
I'll guess that the temperature sensor is located near the thermostat, which is near the upper radiator hose. Good luck and good hunting.
Related, but not in an MB...
I have a "possessed" temperature gauge on the Suburban; after a normal climb during warm-up it will read 210 for a while, the drop really fast to 140 and creep back up to 210. It does this a lot, and it's distracting, so I decided to have the techs have a look.
So far I've found out that:
1. The temperature sensor is not connected to the temperature gauge.
2. The temperature sensor is connected to the engine computer.
3. Disconnecting the sensor (to check it) with the engine running causes an immediate increase in rpm.
NOW I know it's because the computer now thinks the coolant temperature is low, but it is a surprise!
4. The techs have determined that thermostat operation is normal. SCAN I diagnostic shows coolant at 200, the a small drop to 190 and back to 200.
5. They can't explain why a 10 degree coolant drop results in the gauge dropping 60 degrees. I don't quite like their first answer of "it's a bad gauge" because I can't figure out how a gauge would read like this! The sending unit isn't jumping, so what would tell the gauge to jump?
Good luck with your troubleshooting. I don't know if your sensor goes to the gauge, or to a computer.