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Behind Kmart stock swings

Mergers, Acquisitions and TakeoversBuybackCredit RatingsCompanies and CorporationsInvestmentsMoody's CorporationSears, Roebuck and Co.

On Wednesday, shares of Kmart Holding Corp. jumped 7.7 percent on news of its purchase of Sears, Roebuck and Co.

On Thursday, Kmart was still buying Sears under the same terms. But its stock dropped as much as 8.1 percent before rallying a bit to close with a loss of $5.29, or 4.8 percent, at $103.71.

Sears stock, now linked to Kmart's, fared slightly better: After Wednesday's 17 percent gain, its shares dropped nearly 3 percent during trading, but rallied late to close up 1.5 percent, at $53.80.

So what gives? The answer, it seems, lies in shorts.

Not the retailers' khakis, mind you, but traders who borrow stock and then sell it, betting that the price will fall so they can make a profit when they buy back shares to repay them.

When prices are rising, those traders need to cover their bets to minimize their potential losses, known as a "short squeeze."

"There were big shorts on Kmart--have been throughout the rally" that has seen its shares more than quadruple this year, said Todd Salamone, vice president for investment research at Schaeffer's Investment Research Inc. "You may have had some of the shorts getting squeezed, which may have provided some of the buying" Wednesday, he said.

Kmart has had significant short interest, reaching nearly 28 times average daily volume a year ago before retreating this year. Still, in October, according to the most recent data, it was more than 6 times average daily volume and nearly one-quarter of the total publicly available shares, Salamone said.

"You had some big numbers right there," he said.

Jeffrey Maillet of Noble Asset Management LLC in Chicago, which owns Kmart and Sears shares, said, "I thought a lot of it was short-covering early on" Wednesday. "It just didn't have the normal arbitrage feel to it."

Typically, shares of the acquiring firm drop after a merger is announced, while the acquiree's shares generally jump to catch up to whatever premium is being paid. But while Kmart was offering $50 a share and stock, the run-up in Kmart stock pushed Sears shares well above that figure.

As a result, experts said, with many of those short positions covered, some retreat in Kmart stock Thursday was inevitable.

"It was very unusual--let's just put it that way--so you knew there was going to be some giveback on it," Maillet said. "The run-up in the stock has been quite prolific, and I think it's profit-taking" on Thursday.

"A lot of the demand dried up after the shorts were squeezed," Salamone said. "You had such a huge price, those looking to buy Kmart just on the news" were deterred.

In addition, UBS analyst Gary Balter downgraded Kmart shares to "neutral" from "buy," saying the company faces significant risks in its competition with top retailers. "And, given the recent share run, it appears that investors have already set the bar high for this turnaround story," he said.

As for Sears, some experts said its gains reflected perceptions that a higher bid than Kmart's might be in the offing.

Meanwhile, the deal put pressure on the companies' bonds.

The spread, or extra yield, for Sears' 7 percent notes due in 2032 saw yield margins over Treasuries widen in Thursday's session to 218 basis points before coming in again to 215 basis points, according to MarketAxess. The bonds had been quoted at 189 basis points over Treasuries earlier in the week.

Wider spreads mean investors perceive greater risk in owning the company's bonds rather than safe Treasuries, so they demand more yield.

Rating agency Standard & Poor's said it expects the rating for Sears and for the combined Sears Holdings to be in the BB category, a high-yield rating, on completion of the deal.

Kmart, which emerged from bankruptcy in May 2003, isn't rated.

Moody's Investors Service cut Sears' long-term rating one notch, to Baa2, two notches above speculative grade. Moody's expressed concern about the cost of the merger.

It noted that existing shareholders "have an option to convert existing shares into cash, which could create an approximately $5 billion total liability."

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