The wheel should be close to the bottom of the U-shaped sensor, but it must NOT touch it when the motor armature is pressed down to take up the slack. I shoot for 1/16" or less when I'm putting flywheels back on. If it's not hitting the bottom, your picture looks like it's positioned correctly.
If there is no binding in the geartrain, and the motor turns freely around a complete rev of the drivers, my next test is to yank the two pin plug and connect the motor to a bench DC supply on my test rollers and see how much current the motor draws running. Running on the rollers you shouldn't be drawing more than 300-400 milliamps at 6-8 volts. If it's significantly more, I'd suspect the motor. For RCMC equipped locomotives, I put the board on my tester. I don't have a tester for the LCP2/3 boards yet, that's in the project queue, so I just take a spare board and substitute.
I gave up waiting on Micromark rollers to be in stock and rigged up a half-baked test stand to investigate this issue. Just to refresh the problem, this thing starts and moves 12 inches and then stops with the blinking overload light on in the cab.
I disconnected the two-pin motor plug and powered the motor with a dc power supply -the motor ran fine and draws 185 milliamps. I also checked continuity for the four wire plugs that connect the motor tach to the mother board and they are good.
At this point, it seemed the choices are a motor power supply circuit overload or tach feedback (lack of rotation) sensor was shutting it down. To isolate these two, I connected track AC to the roller pickup and frame and left the DC power supply on the motor. I used a universal controller to start the locomotive while I was increasing the dc to the motor, so it rotated. No blinking light was signaled with the motor power circuit out of the system. The unit appeared to run fine.
So, my assumption is the tach speed sensor is not the issue, the problem is in the motor dc power circuit. Somehow it does not like my 185-milliamp load.
Am I missing something and does it sound like the motor dc control circuit?