AS others have suggested you can open the images directly in Ps. As well as saving them out as a JPEG, TIFF, or PSD you can also open them directly from the RAW files. So what I would do is save out .xmp files for the images that you want to stitch, if you don't already auto generate .xmp files anyway. With the xmp files saved you will be able to do as suggested by bildeb0rg and open the images directly, although I thought the automate command was under File, not edit. At least it is in the latest CC version, I can't remember CS5 anymore. If you can directly open the CR2 files into Photomerge then you know that your Ps installation is OK, and you need to be looking at Lr for the problem with opening the images.
I don't see which version of Ps you are using, but if it isn't Ps CS6 or newer, then I don't think it will allow you to directly open CR2 files into the Photomerge tool. Lr uses ACR to render the image to RGB and open it in Ps. When you use an older version of Ps/ACR than you are using within Lr it cannot correctly render the images, and unfortunately Adobe just seems to let it fail without producing any error messages. The same happens if you just try to open the image to Ps too. When you do this normally though Lr will detect the mismatch in versions, and it then gives you the option to have Lr render the image instead. If you accept this, and tick the "do not notify me about this again" option, Lr will just carry on doing the same in the future. Having Lr do the rendering won't work for images sent to the Photomerge tool though.
Alan