Yeah, I suppose his understanding is not consistent, like most of us he has (had) blindspots in which emotion takes over. I, too, found him interesting and frustrating as a writer.
Mostly, I wanted to bring up the distinction between nihilism and what I guess I'll refer to as the buddhist doctrine of "acceptance". I'm not sure how that distinction is to be drawn, since they look quite similar.
Perhaps I could compare it to the difference between agnosticism (or skepticism) and "hard" atheism. The first, here from Dawkins says "There's probably no god, so quit worrying and enjoy your life." The second, a la Penn Jillette says "There is no God". Nihilism seems to make a claim to knowledge closer to the first, as "Nothing matters". Acceptance seems closer to the first, "It probably doesn't matter whether or not it matters." But I could be full of crap with this whole line of argument.
Anyway, your paraphrase here makes it pretty clear that at least part of the time he suffered from the "mechanism = despair" fallacy, so I suppose it doesn't especially matter here.
It has been a while since I've read Watts, but I suspect you're misreading his attitude here. In essence the buddhist (particularly the Zen Buddhist) attitude toward reality is very similar to the materialist view which you endorse. That is, that reality exists, and our opinions about it should be recognized as illusory. This can be confused for nihilism or despair, but really is distinct. Take the universe as it is, and experience it directly, without allowing your expectations of how it should be to affect that experience.
Perhaps he doesn't share this view (though given his background it's hard to believe he wouldn't) although without further context it is difficult to judge from just that quote.
Certainly you can argue about reincarnation and divinity and other aspects of Watts philosophy that you find irrational or dogmatic. But on this individual case you bring up, I suspect he shares your view, and I think you (OP) are projecting these views based on assuming that someone recognizing human life is natural in the same way as vegetable life must consider that a bad thing. But to quote the inscrutable philosophy behind this, that is "perfect in its suchness".
I recall reading (One of Tyler Cowen's books, I think) that happiness is highly correlated with capacity for self-deception. In this case, positive / negative events would have little impact, but not necessarily because people accepted them, but more because the human brain is a highly efficient self-deception machine.
Similarly, a tendency toward depression correlated with an ability to make more realistic predictions about one's life. So I think it may in fact be a particular aspect of human psychology that encourages self-deception and responds negatively to reality.
None of this is to say that these effects can't be reduced or eliminated through various mental techniques, but I don't think it's sufficient to just assert it as cultural.
Well, I hesitate to challenge your reading of Watts, as you've definitely retained more than I have, but I would say that subjectively experienced reality isn't the goal of understanding, rather an attempt to bring once perception closer to actual reality. So I suspect that the doctrine of acceptance would say that if your eyes and ears contradict what appears to be actually happening, then you should let your eyes and ears go.
But of course there is always perception bias, and I'm sure the subject is well covered on LW elsewhere. And, in buddhism all of this is weighted down with a lot of mysticism and even with that this is a highly idealized version anyway. For FSM's sake, the majority of buddhists are sending their prayers up to heaven with incense. So perhaps I should just let it go, eh? :) Anyway, thanks for your comments, it may be helping me set some of my thoughts on all this.