Well, from your post it isn't clear that you've quite "got it" yet.
If you select bitstreaming for DSD it will leave FLAC files unaltered and play them as PCM. With bitstreaming enabled for a DSD DAC, MC will decode all "normal" (PCM-based) formats like FLAC, MP3, AAC, WAV, and so on to PCM like it normally does, but will pass through DSD audio without decoding it at all (so the DSP is bypassed entirely).
However, if you enabled DSD under the Output Encoding setting in the Output Format DSP, then you did not enable bitstreaming. That's not where you do that! You enable bitstreaming under Tools > Options > Audio > Settings > Bitstreaming.
The Output Encoding setting in the DSP has nothing whatsoever to do with bitstreaming. The entire point of the Output Encoding setting is to re-encode all audio output to the selected format. It is useful only when you have a DAC (or connection type) that only supports a particular format. In the past, it was primarily useful to encode multichannel audio to AC3 so it could be sent over a SPDIF link (which can only do stereo PCM, but can do multichannel AC3). But, if you had a weird DAC that could only do DSD (and could not decode normal PCM data) then you'd want to enable this there.
As it says in the wiki, this is quite rare. Output Encoding should almost always be set to None.
Perhaps I've misinterpreted your comment, but I figured it was worth explaining further. If your goal is to have MC play most PCM-based formats as PCM, and to pass through DSD audio directly to your DAC for decoding, automatically, it can do this. You just have to turn it on in the right place.
