I've also heard of this but never seen anything conclusive on it. The big problem is that CD files are read only, and that's impossible for the Windows registry which is a constantly updating facility. Also log files and the Applog folder need to constantly update, and a CD cannot do that of course.
Therfore I think the tales are apocryphal.
In theory a CD-RW running in a CD Writing drive on a computer running EasyCD's Direct CD program might just manage it, but it would be very slow running. However, since the Direct CD wouldn't operate until booting into Windows was completed, there could still be problems with the booting functions that need to write at times.
I've seem this link before from Bart's Bootable CDs site. This link suggests an interesting way of getting round the problem of the need to overwrite files in running an OS from CD. The idea seems to be putting the registry files on to RAM disk. Other error messages can be ignored.