I wondered this for a long time. The answer is easy, but the work is very tedious.
In short, the stance animations are all on one giant image, positioned apart from each other appropriately, like 640x480. In the large image/frames to the system.sff and in the system.def file set the cursor animation to those frames animated. Also, set the cursor position to move around the same distance you've set each stance apart, (e.g. 640x480).
Things to keep in mind.
1. Each stance should have the same amount of frames.
2. From my recollection, the position of each character needs to be positioned in the opposite order, both horizontally and vertically.
3. If you want a cursor image as well, you will also need to include the cursor image and position it according to the select screen as well in the same image as the stances, since you are originally replacing the cursor with stances.
It's a fun thing to try to implement, but only worth doing for a full, closed game. Else, for each character you add to your MUGEN you will need to redo your select screen again and potentially break it where the wrong character will appear or no character at all. That's been my experience.
This has always been an illusive trick of MUGEN, but now that I know and have tried it myself, it's not worth it.
I recommend waiting till MUGEN get's an upgrade and allows animated stances in the select screen one day.
Cheers,
- Twin
Veterans Day