Sheogorath is madness, he's not controlled by madness. So I fully expected him to be coherent and not threaten the PC every two seconds. Madness doesn't equal dark dementia and quirkiness, it can take any form it wishes. So I was happy that SI didn't try too hard to make Sheogorath a total lunatic. It's enough that you know he has very chaotic mind.
He doesn't have to act "mad", Sheogorath never acted mad, he says quirky things but I got the sense that there is a very intensely intelligent pattern to everything he does. I think his madness is an internal thing, a unique state of being whose essential nature is contradiction to expectation. Even Mania and Dementia are merely symbols of Sheo's nature, they're not actual definitions of his state of mind, the Mazken even explain it to a degree "The Shivering Isles are a reflection (not a definition, mind you) of our Lord Sheogorath, divided yet perfect".
Also let's review how Sheogorath interacts with the other princes of Oblivion, he doesn't seem disposed to be quirky or demented in his dealings with them, his mind simply sees things differently as we see when he outwits or defies some of them.
Take for example how he ensnared the Orc warrior who was Malacath's prized child, he used deception. If anything in those tales, "unpredictable" is the only thing we can really expect with regards to his behavior.
But being mad is not about threatening people. There is only a handful of psychological disorders that make the people suffering form them dangerous to others. I'm not calling for Sheo to be dangerous to the player or to threaten his life more than any other daedric prince. As far as coherence goes, that is a problem. Sheo is apparently very coherent which does not sit with most disorders. Mainly dementia and to a lesser degree with mania. I would expect him to be far less coherent (that what Haskill is there for, right?), I would like to see inapropriate emotional responses, like being sad if his wish is fulfilled or not being excited about important things or being excited about details to a great degree and so on. This kind of incoherence would make him seem more disturbing and less pretending.
It is true that as a lord of madness he should be able to embrace and to show any side of it, but in the SI, he only shows one. And to me, he feels more like a teenage kid trying to look tough to attract attention.
As I see Sheo, he should behave to a great degree like someone with schizofrenia or other psychosis. In this case, he could still act in a very intelligent way and could devise very clever plots to achieve his goals. Many people who suffer form this disease are highly intelligent and you can see that their dellusions are very well thought through and quite comolex. To be mad does not only mean a raving lunatic, although I guess he would have this side to his personality as well.
And as far as the "he is madness not madman" argument goes, I always thought that each of the princes were some kind of an archetype of the element they were representing. So, Mehrunes Dagon would in his mind acts and personality encompass destruction and the power of elements. Meridia would represent nature and to degree show everything we tend to connect to nature and thus becoming an archetype of nature itslef. In this, Sheo should be an archetype of mad person. Because madness does never exist as such (unlike nature or elements), it is a state of something else (usually a human mind) so you cannot represent it per se, but only in a conjunction with something (most likely the human mind it is usually tied to). Therefore I think Sheo should be a madman. That does not contradict intelligence, cunning or danger, it only adds to it something more.